Management's Discussion of Results of Operations (Excerpts)
For purposes of readability, Zenith attempts to strip out all tables in excerpts from the Management Discussion. That information is contained elsewhere in our articles. The idea of this summary is simply to review how well we believe Management does its reporting. Also, this highlights what Management believes is important.
In our Decision Matrix at the end of each article, a company with 0 to 2 gets a "-1", and 3 to 5 gets a "+1."
On a scale of 0 to 5, 5 being best, Zenith rates this company's Management's Discussion as a 5.
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, medical devices 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, complex printed circuit board assembly, 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 and automotive 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, lenses, prisms, mirrors, laser components, and substrates (collectively referred to as “customized optics”) and other custom and standard borosilicate, clear fused quartz, and synthetic fused silica glass products (collectively referred to as “customized glass”). 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. Business acquisition On September 14, 2016, we acquired Global CEM Solutions Ltd. and all of its subsidiaries (collectively, “Exception EMS”), a privately-held group located in Wiltshire, United Kingdom, for cash consideration of approximately $13.0 million, net of cash acquired. Exception EMS provides contract electronics manufacturing services primarily to the European electronics market with innovative solutions, adding value to the design, manufacture and testing of printed circuit board assemblies. Its customers include industrial, energy, aerospace and defense companies, with approximately 80% of its revenue derived from customers in Europe. See Note 9—Business acquisition to the consolidated financial statements for further details. Fiscal years We utilize a 52-53 week fiscal year ending on the Friday in June closest to June 30. Fiscal year 2017 ended on June 30, 2017 and consisted of 53 weeks. Fiscal year 2016 and fiscal year 2015 ended on June 24, 2016 and June 26, 2015, respectively, and each consisted of 52 weeks. Revenues We believe our ability to expand our relationships with existing customers and attract new customers is due to a number of factors, including our broad range of complex engineering and manufacturing service offerings, flexible low-cost manufacturing platform, process optimization capabilities, advanced supply chain management, excellent customer service and experienced management team. Although we expect the prices we charge for our manufactured products to decrease over time (partly as a result of competitive market forces), we still believe we will be able to maintain favorable pricing for our services because of our ability to reduce cycle time, adjust our product mix by focusing on more complicated products, improve product quality and yields, and reduce material costs for the products we manufacture. We believe these capabilities will enable us to help our OEM customers reduce their manufacturing costs while maintaining or improving the design, quality, reliability and delivery times of their products. Because we depend upon a small number of customers for a significant percentage of our total revenues, a reduction in orders from, a loss of, or any other adverse actions by, any one of these customers would reduce our revenues and could have a material adverse effect on our business, operating results and share price. Moreover, our customer concentration increases the concentration of our accounts receivable and payment default by any of our key customers will negatively impact our exposure. Many of our existing and potential customers have substantial debt burdens, have experienced financial distress or have static or declining revenues, all of which may be exacerbated by the continued uncertainty in the global economies. Certain customers have gone out of business or have been acquired or announced their withdrawal from segments of the optics market. We generate significant accounts payable and inventory for the services that we provide to our customers, which could expose us to substantial and potentially unrecoverable costs if we do not receive payment from our customers. Therefore, any financial difficulties that our key customers experience could materially and adversely affect our operating results and financial condition by generating charges for inventory write-offs, provisions for doubtful accounts, and increases in working capital requirements due to increased days inventory and in accounts receivable. Furthermore, reliance on a small number of customers gives those customers substantial purchasing power and leverage in negotiating contracts with us. In addition, although we enter into master supply agreements with our customers, the level of business to be transacted under those agreements is not guaranteed. Instead, we are awarded business under those agreements on a project-by-project basis. Some of our customers have at times significantly reduced or delayed the volume of manufacturing services that they order from us. If we are unable to maintain our relationships with our existing significant customers, our business, financial condition and operating results could be harmed. Revenues by Geography We generate revenues from three geographic regions: North America, Asia-Pacific, and Europe. Revenues are attributed to a particular geographic area based on the bill-to-location of our customers, notwithstanding that our customers may ultimately ship their products to end customers in a different geographic region. The substantial majority of our revenues are derived from our manufacturing facilities in Asia-Pacific. The percentage of our revenues generated from a bill-to-location outside of North America increased from 46.2% in fiscal year 2016 to 53.4% in fiscal year 2017, which was partially due to an increase in sales to our customers in Europe due to the acquisition of Exception EMS in September 2016. We expect that the portion of our future revenues attributable to customers in regions outside of North America will continue to increase as compared with the portion of revenues attributable to such customers during fiscal year 2017. Our Contracts We enter into supply agreements with our customers which generally have an initial term of up to three years, subject to automatic renewals for subsequent one-year terms unless expressly terminated. Although there are no minimum purchase requirements in our supply agreements, our customers provide us with rolling forecasts of their demand requirements. Our supply agreements generally include provisions for pricing and periodic review of pricing, consignment of our customer’s unique production equipment to us, and the sharing of benefits from cost-savings derived from our efforts. We are generally required to purchase materials, which may include long lead-time materials and materials that are subject to minimum order quantities and/or non-cancelable or non-returnable terms, to meet the stated demands of our customers. After procuring materials, we manufacture products for our customers based on purchase orders that contain terms regarding product quantities, delivery locations and delivery dates. Our customers generally are obligated to purchase finished goods that we have manufactured according to their demand requirements. Materials that are not consumed by our customers within a specified period of time, or are no longer required due to a product’s cancellation or end-of-life, are typically designated as excess or obsolete inventory under our contracts. Once materials are designated as either excess or obsolete inventory, our customers are typically required to purchase such inventory from us even if they have chosen to cancel production of the related products. Cost of Revenues The key components of our cost of revenues are material costs, employee costs, and infrastructure-related costs. Material costs generally represent the majority of our cost of revenues. Several of the materials we require to manufacture products for our customers are customized for their products and often sourced from a single supplier or in some cases, our own subsidiaries. Shortages from sole-source suppliers due to yield loss, quality concerns and capacity constraints, among other factors, may increase our expenses and negatively impact our gross profit margin or total revenues in a given quarter. Material costs include scrap material. Historically, scrap rate diminishes during a product’s life cycle due to process, fixturing and test improvement and optimization. A second significant element of our cost of revenues is employee costs, including indirect employee costs related to design, configuration and optimization of manufacturing processes for our customers, quality testing, materials testing and other engineering services; and direct costs related to our manufacturing employees. Direct employee costs include employee salaries, insurance and benefits, merit-based bonuses, recruitment, training and retention. Historically, our employee costs have increased primarily due to increases in the number of employees necessary to support our growth and, to a lesser extent, costs to recruit, train and retain employees. Our cost of revenues is significantly impacted by salary levels in Thailand, the PRC and the United Kingdom, the fluctuation of the Thai baht, RMB and GBP against our functional currency, the U.S. dollar, and our ability to retain our employees. We expect our employee costs to increase as wages continue to increase in Thailand and the PRC. Wage increases may impact our ability to sustain our competitive advantage and may reduce our profit margin. We seek to mitigate these cost increases through improvements in employee productivity, employee retention and asset utilization. Our infrastructure costs are comprised of depreciation, utilities, facilities management and overhead costs. Most of our facility leases are long-term agreements. Our depreciation costs include buildings and fixed assets, primarily at our Pinehurst campus in Thailand, and capital equipment located at each of our manufacturing locations. During fiscal year 2017, fiscal year 2016 and fiscal year 2015, discretionary merit-based bonus awards were made to our non-executive employees. Charges included in cost of revenues for bonus awards to non-executive employees were $3.2 million, $2.8 million and $2.4 million for fiscal year 2017, fiscal year 2016 and fiscal year 2015, respectively. Share-based compensation expense included in cost of revenues was $5.3 million, $2.0 million and $1.5 million for fiscal year 2017, fiscal year 2016 and fiscal year 2015, respectively. We expect to incur incremental costs of revenue as a result of our planned expansion into new geographic markets, though we are not able to determine the amount of these incremental expenses. Selling, General and Administrative Expenses Our SG&A expenses primarily consist of corporate employee costs for sales and marketing, general and administrative and other support personnel, including research and development expenses related to the design of customized optics and glass, travel expenses, legal and other professional fees, share-based compensation expense and other general expenses not related to cost of revenues. In fiscal year 2018, we expect our SG&A expenses will increase on an absolute dollar basis and decrease as a percentage of revenue compared with fiscal year 2017. The compensation committee of our board of directors approved a fiscal year 2017 executive incentive plan with quantitative objectives, based on achieving certain revenue and gross margin targets for our fiscal year ended June 30, 2017. Bonuses under our fiscal year 2017 executive incentive plan are payable after the end of fiscal year 2017. In fiscal year 2016, the compensation committee approved a fiscal year 2016 executive incentive plan with quantitative objectives, based on achieving certain revenue and non-GAAP earnings per share targets for our fiscal year ended June 24, 2016, as well as qualitative objectives, based on achieving individual performance goals. In the three months ended September 30, 2016, the compensation committee awarded bonuses to our executive employees for Company and individual achievements of performance under our fiscal 2016 executive incentive plan. Discretionary merit-based bonus awards were also available to our non-executive employees and were payable as of June 30, 2017. Charges included in SG&A expenses for bonus distributions to non-executive and executive employees were $4.4 million, $4.7 million and $3.6 million for fiscal year 2017, fiscal year 2016 and fiscal year 2015, respectively. Share-based compensation expense included in SG&A expenses was $21.2 million, $7.9 million and $6.6 million for fiscal year 2017, fiscal year 2016 and fiscal year 2015, respectively. Additional Financial Disclosures Foreign Exchange As a result of our international operations, we are exposed to foreign exchange risk arising from various currency exposures primarily with respect to the Thai baht. Although a majority of our total revenues is denominated in U.S. dollars, a substantial portion of our payroll plus certain other operating expenses are incurred and paid in Thai baht. The exchange rates between the Thai baht and the U.S. dollar have fluctuated substantially in recent years and may continue to fluctuate substantially in the future. We report our financial results in U.S. dollars and our results of operations have been and may continue to be negatively impacted owing to appreciation of the Thai baht against the U.S. dollar. Smaller portions of our expenses are incurred in a variety of other currencies, including RMB, GBP, Canadian dollars, Euros and Japanese yen, the appreciation of which may also negatively impact our financial results. In order to manage the risks arising from fluctuations in foreign currency exchange rates, we use derivative instruments. We may enter into exchange currency forward or put option contracts to manage foreign currency exposures associated with certain assets and liabilities and other forecasted foreign currency transactions and may designate these instruments as hedging instruments. The forward and put option contracts generally have maturities of up to 12 months. All foreign currency exchange contracts are recognized in the consolidated balance sheet as other current assets and accrued expenses at fair value. Gain or loss on our forward and put option contracts generally offset the assets, liabilities, and transactions economically hedged. The Thai baht assets represent cash and cash equivalents, trade accounts receivable, deposits and other current assets. The Thai baht liabilities represent trade accounts payable, accrued expenses, income tax payable and other payables. We manage our exposure to fluctuations in foreign exchange rates by the use of foreign currency contracts and offsetting assets and liabilities denominated in the same currency in accordance with management’s policy. As of June 30, 2017 and June 24, 2016, there was $1.0 million and $84.5 million in foreign currency forward contracts, respectively, outstanding on the Thai baht payables. The RMB assets represent cash and cash equivalents, trade accounts receivable, and other current assets. The RMB liabilities represent trade accounts payable, accrued expenses, income tax payable and other payables. As of June 30, 2017 and June 24, 2016, we did not have any derivative contracts denominated in RMB. The GBP assets primarily represent cash, trade accounts receivable, and property, plant and equipment, net. The GBP liabilities primarily represent short-term loans, trade accounts payable and other payables. As of June 30, 2017, we did not have any derivative contracts denominated in GBP. For fiscal year 2017 and fiscal year 2016, we recorded unrealized loss of $0.02 million and $1.8 million, respectively, for the changes in fair value of derivatives that are not designated as hedging instruments in the consolidated statements of operations and comprehensive income. Currency Regulation and Dividend Distribution Foreign exchange regulation in the PRC is primarily governed by the following rules: • Foreign Currency Administration Rules, as amended on August 5, 2008, or the Exchange Rules; • Administration Rules of the Settlement, Sale and Payment of Foreign Exchange (1996), or the Administration Rules; and • Notice on Perfecting Practices Concerning Foreign Exchange Settlement Regarding the Capital Contribution by Foreign-invested Enterprises, as promulgated by the State Administration of Foreign Exchange, or State Administration of Foreign Exchange (“SAFE”), on August 29, 2008, or Circular 142. Under the Exchange Rules, RMB is freely convertible into foreign currencies for current account items, including the distribution of dividends, interest payments, trade and service-related foreign exchange transactions. However, conversion of RMB for capital account items, such as direct investments, loans, security investments and repatriation of investments, is still subject to the approval of SAFE. Under the Administration Rules, foreign-invested enterprises may only buy, sell, or remit foreign currencies at banks authorized to conduct foreign exchange business after providing valid commercial documents and relevant supporting documents and, in the case of capital account item transactions, obtaining approval from SAFE. Capital investments by foreign-invested enterprises outside of the PRC are also subject to limitations, which include approvals by the Ministry of Commerce, SAFE and the State Development and Reform Commission. Circular 142 regulates the conversion by a foreign-invested company of foreign currency into RMB by restricting how the converted RMB may be used. Circular 142 requires that the registered capital of a foreign-invested enterprise settled in RMB converted from foreign currencies may only be used for purposes within the business scope approved by the applicable governmental authority and may not be used for equity investments within the PRC. In addition, SAFE strengthened its oversight of the flow and use of the registered capital of foreign-invested enterprises settled in RMB converted from foreign currencies. The use of such RMB capital may not be changed without SAFE’s approval and may not be used to repay RMB loans if the proceeds of such loans have not been used. On January 5, 2007, SAFE promulgated the Detailed Rules for Implementing the Measures for the Administration on Individual Foreign Exchange, or the Implementation Rules. Under the Implementation Rules, PRC citizens who are granted share options by an overseas publicly-listed company are required, through a PRC agent or PRC subsidiary of such overseas publicly-listed company, to register with SAFE and complete certain other procedures. In addition, the General Administration of Taxation has issued circulars concerning employee share options. Under these circulars, our employees working in the PRC who exercise share options will be subject to PRC individual income tax. Our PRC subsidiary has obligations to file documents related to employee share options with relevant tax authorities and withhold individual income taxes of those employees who exercise their share options. Furthermore, our transfer of funds to our subsidiaries in Thailand and the PRC are each subject to approval by governmental authorities in case of an increase in registered capital, or subject to registration with governmental authorities in case of a shareholder loan. These limitations on the flow of funds between our subsidiaries and us could restrict our ability to act in response to changing market conditions. Income Tax Our effective tax rate is a function of the mix of tax rates in the various jurisdictions in which we do business. We are domiciled in the Cayman Islands. Under the current laws of the Cayman Islands, we are not subject to tax in the Cayman Islands on income or capital gains. We have received this undertaking for a 20-year period ending August 24, 2019, and after the expiration date, we may request a renewal with the office of the Clerk of the Cabinet for another 20 years. Throughout the period of our operations in Thailand, we have generally received income tax and other incentives from the Thailand Board of Investment. Preferential tax treatment from the Thai government in the form of a corporate tax exemption is currently available to us through June 2020 on income generated from projects to manufacture certain products at our Pinehurst campus. Such preferential tax treatment is contingent on various factors, including the export of our customers’ products out of Thailand and our agreement not to move our manufacturing facilities out of our current province in Thailand for at least 15 years from the date on which preferential tax treatment was granted (i.e., at least until June 2020). In March 2016, the Thailand Revenue Department announced a permanent decrease of corporate income tax rates to 20% for tax periods beginning on or after January 1, 2016. As a result, the corporate income tax rate for our Thai subsidiary is expected to remain at 20% from fiscal year 2017 onward. Critical Accounting Policies and Use of Estimates We prepare our consolidated financial statements in conformity with U.S. GAAP, which requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent liabilities on the date of the consolidated financial statements and the reported amounts of revenues and expenses during the financial reporting period. We continually evaluate these estimates and assumptions based on the most recently available information, our own historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Because the use of estimates is an integral component of the financial reporting process, actual results could differ from those estimates. Some of our accounting policies require higher degrees of judgment than others in their application. We consider the policies discussed below to be critical to an understanding of our consolidated financial statements, as their application places the most significant demands on our management’s judgment. A quantitative sensitivity analysis is provided where such information is reasonably available, can be reliably estimated, and provides material information to investors. The amounts used to assess sensitivity are included for illustrative purposes only and do not represent management’s predictions of variability. Revenue Recognition We recognize revenue when it is realized or realizable and earned. We consider revenue realized or realizable and earned when there is persuasive evidence of an arrangement, delivery has occurred, the sales price is fixed or determinable, and collectability is reasonably assured. Delivery does not occur until products have been shipped or services have been provided, risk of loss has transferred and in cases where formal acceptance is required, customer acceptance has been obtained or customer acceptance provisions have lapsed. In situations where a formal acceptance is required but the acceptance only relates to whether the product meets its published specifications, revenue is recognized upon shipment provided all other revenue recognition criteria are met. The sales price is not considered to be fixed or determinable until all contingencies related to the sale have been resolved. We reduce revenue for rebates and other similar allowances. Revenue is recognized only if these estimates can be reliably determined. Our estimates are based on historical results taking into consideration the type of customer, the type of transaction, and the specifics of each arrangement. In addition to the aforementioned general policies, certain customers may request us to store finished products purchased by them at the Company’s warehouse. In these instances, we receive a written request from the customer asking us to hold the inventory at our warehouse and the ordered goods are segregated in our warehouse from other inventory and cannot be used to fulfil other customer orders. In these situations, revenue is only recognized when persuasive evidence of the sales arrangement exists, the goods are completed and ready for shipment, pricing is fixed or determinable, collection is reasonable assured, and title and risk of loss have passed to the customer. Long-Lived Assets We review property, plant and equipment for impairment when events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. An impairment loss is recognized when the carrying amount of a long-lived asset or assets group exceeds its fair value. Recoverability of property and equipment is measured by comparing its carrying amount to the projected undiscounted cash flows the property and equipment are expected to generate. If such assets are considered to be impaired, the impairment loss recognized, if any, is the amount by which the carrying amount of the property and equipment exceeds its fair value. Allowance for Doubtful Accounts We perform ongoing credit evaluations of our customers’ financial condition and make provisions for doubtful accounts based on the outcomes of these credit evaluations. We evaluate the collectability of our accounts receivable based on specific customer circumstances, current economic trends, historical experience with collections, and the age of past due receivables. Unanticipated changes in the liquidity or financial position of our customers may require additional provisions for doubtful accounts. Under our specific identification method, it is not practical to assess the sensitivity of our estimates. Inventory Valuation Our inventory is stated at the lower of cost (on a first-in, first-out basis) or market value. Our industry is characterized by rapid technological change, short-term customer commitments, and rapid changes in demand. We make provisions for estimated excess and obsolete inventory based on regular reviews of inventory quantities on hand and the latest forecasts of product demand and production requirements from our customers. If actual market conditions or our customers’ product demands are less favorable than those projected, additional provisions may be required. In addition, unanticipated changes in liquidity or the financial positions of our customers or changes in economic conditions may require additional provisions for inventory due to our customers’ inability to fulfill their contractual obligations. During fiscal year 2017 and fiscal year 2016, a change of 10% for excess and obsolete materials, based on product demand and production requirements from our customers, would have affected our net income by approximately $0.3 million and $0.2 million, respectively. Deferred Income Taxes Our deferred income tax assets represent temporary differences between the carrying amount and the tax basis of existing assets and liabilities that will result in deductible and payable amounts in future years, including net operating loss carryforwards. Based on estimates, the carrying value of our net deferred tax assets assumes that it is more likely than not that we will be able to generate sufficient future taxable income in certain tax jurisdictions to realize these deferred income tax assets. Our judgments regarding future profitability may change owing to future market conditions, changes in U.S. or international tax laws, or other factors. If these estimates and related assumptions change in the future, we may be required to increase or decrease our valuation allowance against the deferred tax assets, resulting in additional or lesser income tax expense. As of June 30, 2017 and June 24, 2016, we have determined that it is more likely than not that deferred tax asset attributable to a subsidiary in the United States will not be realized, primarily due to uncertainties related to the subsidiary’s ability to utilize its operating loss carryforward before they expire. As of June 30, 2017 and June 24, 2016, we assessed all of our deferred tax assets as more likely than not to be realizable and, accordingly, recognized a valuation allowance for deferred tax assets of $6.4 million and $4.9 million, respectively. We assess tax positions in a previously filed tax return or a position expected to be taken in a future tax return that is reflected in measuring current or deferred income tax assets and liabilities for interim or annual periods, based on the technical merits of the position. We apply a “more likely than not” basis (i.e., a likelihood greater than 50 percent), in accordance with the authoritative guidance, and recognize a tax provision in the consolidated financial statements for an uncertain tax position that would not be sustained. Share-Based Compensation Awards granted, including share options, restricted share units and performance share units are accounted for by recognizing the cost of employee services received in exchange for awards of equity instruments, based on the fair value of those awards, in the consolidated financial statements over the requisite service period. In determining the fair value of share option awards, we are required to make estimates of expected dividends to be issued, expected volatility of our shares, expected forfeitures of the awards, risk free interest rates for the expected terms of the awards and expected terms of the awards. For accounting purposes only, the fair value of each option grant is estimated using the Black-Scholes-Merton option pricing model, which takes into account the following factors: (1) the exercise price of the options; (2) the fair value of the underlying ordinary shares; (3) the expected life of the options; (4) the expected volatility of the underlying ordinary shares; (5) the risk-free interest rate during the expected life of the options; and (6) the expected dividend yield of the underlying ordinary shares. However, these fair values are inherently uncertain and highly subjective. The exercise price of the options is stated in the option agreements. The expected life of the options involves estimates of the anticipated timing of the exercise of the vested options. The expected volatility is based on the historical volatility of our share price. We have applied the U.S. Treasury Bill interest rate with a maturity date similar to the expected life of our options as the risk-free interest rate and assumed a dividend yield for periods when we paid dividends. The fair value of restricted share units and performance share units are based on the market value of our ordinary shares on the date of grant. The determination of our share-based compensation expense for both current and future periods requires the input of assumptions, including estimated forfeitures and the price volatility of the underlying ordinary shares. We estimate forfeitures based on past employee retention rates and our expectations of future retention rates, and we will prospectively revise our forfeiture rates based on actual history. Our share-based compensation expense may change based on changes to our actual forfeitures. Intangibles Intangibles are stated at historical cost less amortization. Amortization of customer relationships is calculated using the accelerated method as to reflect the pattern in which the economic benefits of the intangible assets are consumed. Amortization of other intangibles is calculated using the straight-line method. Business acquisition For the acquisition of Exception EMS, we allocated the fair value of purchase consideration to the assets acquired and liabilities assumed based on their fair values at the acquisition date. The allocation of consideration to the individual net assets has been finalized. The acquired intangible assets, which consist of customer relationships and backlog, are recorded as intangibles in the consolidated balance sheets. The fair value of the acquired intangible assets was determined based on the multi-period excess earnings method. We review intangibles for impairment whenever changes or circumstances indicate the carrying amount may not be recoverable. Goodwill Goodwill arising from the acquisition is primarily attributable to the ability to expand future products and services and the assembled workforce. Goodwill is reviewed annually for impairment or more frequently whenever changes or circumstances indicate the carrying amount of goodwill may not be recoverable. Results of Operations We operate and internally manage a single operating segment. As such, discrete information with respect to separate product lines and segments is not accumulated. We utilize a 52-53 week fiscal year ending on the Friday in June closest to June 30. Fiscal year 2017 ended on June 30, 2017 and consisted of 53 weeks. Fiscal year 2016 and fiscal year 2015 ended on June 24, 2016 and June 26, 2015, respectively, and each consisted of 52 weeks. Comparison of Fiscal Year 2017 with Fiscal Year 2016 Total revenues. Our total revenues increased by $443.7 million, or 45.4%, to $1.4 billion for fiscal year 2017, compared with $976.7 million for fiscal year 2016. This increase was primarily due to (1) an increase in customers’ demand for both optical and non-optical communication manufacturing services for fiscal year 2017; and (2) the positive impact from an additional week of revenue during fiscal year 2017. Revenues from optical communications products represented 78.0% of our total revenues for fiscal year 2017, compared with 74.5% for fiscal year 2016. Cost of revenues. Our cost of revenues increased by $391.8 million, or 45.7%, to $1.3 billion, or 87.9% of total revenues, for fiscal year 2017, compared with $857.2 million, or 87.8% of total revenues, for fiscal year 2016. The increase in cost of revenues was primarily due to a proportional increase in sales volume. The increase in cost of revenues also included an increase of $3.3 million in share-based compensation expenses, primarily due to a higher number of restricted and performance share units granted to our executives when compared to the prior period. Gross profit. Our gross profit increased by $51.9 million, or 43.5%, to $171.5 million, or 12.1% of total revenues, for fiscal year 2017, compared with $119.5 million, or 12.2% of total revenues, for fiscal year 2016. SG&A expenses. Our SG&A expenses increased by $15.9 million, or 31.9%, to $65.6 million, or 4.6% of total revenues, for fiscal year 2017, compared with $49.8 million, or 5.1% of total revenues, for fiscal year 2016. Our SG&A expenses increased in absolute dollars during fiscal year 2017, compared with fiscal year 2016, mainly due to (1) an increase in share-based compensation expenses of $13.2 million, partially due to the recognition of $4.3 million related to accelerated vesting of equity awards held by executives during fiscal year 2017; (2) $2.8 million of SG&A expenses from companies we acquired in September 2016; and (3) an increase of $1.5 million related to merger and acquisition activities. Operating income. Our operating income increased by $36.0 million to $105.8 million, or 7.5% of total revenues, for fiscal year 2017, compared with $69.8 million, or 7.1% of total revenues, for fiscal year 2016. Interest income. Our interest income increased by $0.4 million to $2.0 million for fiscal year 2017, compared with $1.5 million for fiscal year 2016. The increase was primarily due to an increase in our average outstanding cash and marketable securities balances and interest rates. Interest expense. Our interest expense increased by $1.8 million to $3.3 million for fiscal year 2017, compared with $1.6 million for fiscal year 2016. The increase was primarily due to an increase in the average balance of our outstanding bank borrowings. Income before income taxes. We recorded income before income taxes of $103.9 million for fiscal year 2017, compared with $68.2 million for fiscal year 2016. Income tax expense. Our provision for income tax reflects an effective tax rate of 5.5% for fiscal year 2017, compared with an effective tax rate of 6.7% for fiscal year 2016. The decrease was primarily due to the fact that we had higher income not subject to tax during fiscal year 2017 as compared with fiscal year 2016. Net income. We recorded net income of $97.1 million, or 6.8% of total revenues, for fiscal year 2017, compared with net income of $61.9 million, or 6.3% of total revenues, for fiscal year 2016. Other comprehensive (loss) income. We recorded other comprehensive loss of $0.9 million, or 0.1% of total revenues, for fiscal year 2017, compared with other comprehensive income of $0.6 million, or 0.1% of total revenues, for fiscal year 2016. Comparison of Fiscal Year 2016 with Fiscal Year 2015 Total revenues. Our total revenues increased by $203.2 million, or 26.3%, to $976.7 million for fiscal year 2016, compared with $773.6 million for fiscal year 2015. This increase was primarily due to (1) an increase in customers’ demand for both optical and non-optical communication manufacturing services for fiscal year 2016 and (2) our inability to recognize $16.5 million of consignment revenue during fiscal year 2015 because of certain consignment revenue recognition issues previously disclosed that resulted in lower revenue in fiscal year 2015. Revenues from optical communications products represented 74.5% of our total revenues for fiscal year 2016, compared with 71.5% for fiscal year 2015. Cost of revenues. Our cost of revenues increased by $171.4 million, or 25.0%, to $857.2 million, or 87.8% of total revenues, for fiscal year 2016, compared with $685.8 million, or 88.6% of total revenues, for fiscal year 2015. The increase in cost of revenues on an absolute dollar basis was primarily due to an increase in sales volume, which was partially offset by a more favorable product mix. Cost of revenues also included non-cash share-based compensation expense of $2.0 million for fiscal year 2016, compared with $1.5 million for fiscal year 2015. Gross profit. Our gross profit increased by $31.8 million, or 36.2%, to $119.5 million, or 12.2% of total revenues, for fiscal year 2016, compared with $87.8 million, or 11.4% of total revenues, for fiscal year 2015. The increase in gross profit margin during fiscal year 2016, compared with fiscal year 2015, was primarily related to an increase in sales volume and more favorable product mix during fiscal year 2016. SG&A expenses. Our SG&A expenses increased by $10.3 million, or 26.1%, to $49.8 million, or 5.1% of total revenues, for fiscal year 2016, compared with $39.5 million, or 5.1% of total revenues, for fiscal year 2015. Our SG&A expenses increased in absolute dollars during fiscal year 2016, compared with fiscal year 2015, mainly due to (1) an increase of $4.6 million in expenses relating to our new manufacturing facility in the United States which commenced operations during the third quarter of fiscal year 2015; (2) the recognition of $1.4 million in severance and related benefit costs to executives who left the Company during fiscal year 2016; (3) an increase of $1.3 million in sales and marketing expenses; and (4) an increase of $1.0 million in executive and management bonuses, salaries, and other benefits. Other income related to flooding. In fiscal year 2016, we recognized other income related to flooding of $0.04 million, which consisted of a $0.9 million final payment from an insurer against our claim for flood damage, offset by expenses in relation to flood of $0.86 million, which mainly consisted of $0.6 million of repaired cost of equipment and $0.2 million of inventory losses. Expenses related to reduction in workforce. During fiscal year 2015, we implemented a reduction in workforce and incurred expenses of approximately $1.2 million, which represented severance and benefits costs associated with the termination of approximately 100 employees in accordance with contractual obligations and local regulations. No expenses related to reduction in workforce were incurred during fiscal year 2016. Operating income. Our operating income increased by $22.6 million to $69.8 million, or 7.1% of total revenues, for fiscal year 2016, compared with $47.2 million, or 6.1% of total revenues, for fiscal year 2015. Interest income. Our interest income increased by $0.3 million to $1.5 million for fiscal year 2016, compared with $1.3 million for fiscal year 2015. This increase mainly was due to increases in the amount on which interest is earned as well as an increase in interest rates. Interest expense. Our interest expense increased by $1.0 million to $1.6 million for fiscal year 2016, compared with $0.6 million for fiscal year 2015. This increase was due to increases in average loan balances resulting from drawdown of revolving loans during the year. Income before income taxes. We recorded income before income taxes of $68.2 million for fiscal year 2016, compared with $47.6 million for fiscal year 2015. Income tax expense. Our provision for income tax reflects an effective tax rate of 6.7% for fiscal year 2016, compared with an effective tax rate of 6.3% for fiscal year 2015. The increase was primarily due to the fact that we had higher taxable income during fiscal year 2016 as compared with fiscal year 2015. Net income. We recorded net income of $61.9 million, or 6.3% of total revenues, for fiscal year 2016, compared with net income of $43.6 million, or 5.6% of total revenues, for fiscal year 2015. Other comprehensive income (loss). We recorded other comprehensive income of $0.6 million, or 0.1% of total revenues, for fiscal year 2016, compared with other comprehensive loss of $0.04 million, or 0.01% of total revenues, for fiscal year 2015. Liquidity and Capital Resources We primarily finance our operations through cash flow from operations activities. As of June 30, 2017 and June 24, 2016, we had cash, cash equivalents, and marketable securities of $285.3 million and $284.5 million, respectively, and outstanding debt of $71.1 million and $60.4 million, respectively. Our cash and cash equivalents, which primarily consist of cash on hand, demand deposits and liquid investments with maturities of three months or less, are placed with banks and other financial institutions. The weighted average interest rate on our cash and cash equivalents for fiscal year 2017, fiscal year 2016 and fiscal year 2015 was 0.6%, 0.7% and 0.7%, respectively. Our cash investments are made in accordance with an investment policy approved by the Audit Committee of our Board of Directors. In general, our investment policy requires that securities purchased be rated A1, P-1, F1 or better. No security may have an effective maturity that exceeds three years. Our investments in fixed income securities are primarily classified as available-for-sale securities and are recorded at fair value in the consolidated balance sheets. The cost of securities sold is based on the specific identification method. Unrealized gains and losses on these securities are recorded as other comprehensive (loss) income and are reported as a separate component of shareholders’ equity. During fiscal year 2017, we borrowed a revolving loan of $27.5 million and repaid a term loan of $18.1 million under our syndicated senior credit facility agreement (“Facility Agreement”). As a result, as of June 30, 2017, we had a long-term borrowing of $36.4 million and short-term borrowing of $34.0 million under our Facility Agreement. To better manage our cash on hand, we also held investments in short-term marketable securities of $151.5 million as of June 30, 2017. We believe that our current cash, cash equivalents, marketable securities, cash flow from operations, and funds available through our credit facility will be sufficient to meet our working capital and capital expenditure needs for the next 12 months. In December 2015, we began construction of a new manufacturing facility at our campus in Chonburi, Thailand, which we substantially completed in the first quarter of fiscal year 2017. We begin our operations at this new facility in the fourth quarter of fiscal year 2017. We believe that our current manufacturing capacity is sufficient to meet our anticipated production requirements for at least the next few quarters. We maintain a long-term loan associated with construction of production facilities at our Pinehurst campus in Thailand that will come due within the next 12 months. Operating Activities Net cash provided by operating activities increased by $23.8 million, or 50.6%, to $70.9 million for fiscal year 2017, compared with net cash provided by operating activities of $47.1 million for fiscal year 2016. This increase was due to an increase in net income of $35.2 million from revenue growth, depreciation and amortization of $6.4 million from additional investments in equipment to support our new facility in Chonburi, Thailand, and share-based compensation of $16.6 million mainly related to additional grants of equity awards to employees during the year. These were offset with decreases in movement of trade accounts payable, and other current and non-current liabilities of $18.0 million and $14.6 million, respectively. Net cash provided by operating activities decreased by $5.5 million, or 10.5%, to $47.1 million for fiscal year 2016, compared with net cash provided by operating activities of $52.6 million for fiscal year 2015. This decrease was due to an increase in net income of $18.3 million, a decrease of $35.8 million in cash payment to vendors, offset by a decrease of $27.2 million in cash collection from customers and a decrease of $44.2 million in inventory as a result of higher customer demand during fiscal year 2016; as well as a decrease of $9.1 million in other current and non-current liabilities mainly from payable related to the new manufacturing facility in Thailand. Investing Activities Net cash used in investing activities increased by $50.9 million, or 128.7%, to $90.6 million for fiscal year 2017, compared with net cash used in investing activities of $39.6 million for fiscal year 2016. The increase was primarily due to an increase of $27.6 million in the purchase of property, plant and equipment primarily for our new facility in Chonburi, Thailand, a net increase of $11.4 million in marketable securities and the net payment of $9.9 million in connection with the acquisition of Exception EMS. Net cash used in investing activities decreased by $155.9 million, or 79.7%, to $39.6 million for fiscal year 2016, compared with net cash used in investing activities of $195.5 million for fiscal year 2015. The decrease was primarily due to a net increase in available-for-sales securities of $144.6 million during fiscal year 2016. Financing Activities Net cash provided by financing activities decreased by $9.4 million, or 41.2%, to $13.4 million for fiscal year 2017, compared with net cash provided by financing activities of $22.9 million for fiscal year 2016. This decrease was primarily due to a decrease of $50.0 million in proceeds from long-term bank loans, and an increase of $12.1 million in the repayment of long-term bank loans. These were offset by a net increase of short-term loan from bank of $50.8 million. Net cash provided by financing activities increased by $0.3 million, or 1.4%, to $22.9 million for fiscal year 2016, compared with net cash provided by financing activities of $22.5 million for fiscal year 2015. This increase was primarily due to an increase of $38.0 million in proceeds from bank loans and an increase of $4.6 million in proceeds from the issuance of ordinary shares under our employee share option plans, offset by an increase of $41.5 million from the repayments of loans. Contractual Obligations Interest expense obligation reflects the interest rate on long-term debt obligation as of June 30, 2017. The interest rates ranged between 3.05% and 3.56%. For further discussion of long-term and short-term debt obligations, see Note 13 of our audited consolidated financial statements. Severance liabilities as of June 30, 2017 are determined based on management assumptions, see Note 14 of our audited consolidated financial statements. As of June 30, 2017, our long-term debt obligations consisted of approximately $36.4 million outstanding under a loan agreement. The loan prescribes maximum ratios of debt to equity and minimum levels of debt service coverage ratios (i.e., earnings before interest expenses and depreciation and amortization plus cash on hand minus short-term debts divided by current portion of long-term debts plus interest expenses). These financial ratio covenants could restrict our ability to incur additional indebtedness and limit our ability to use our cash. Our long-term debt obligation also includes customary events of default. As of June 30, 2017, we were in compliance with our long-term loan agreements. Nonetheless, in the event of a default on these loans or a breach of a financial ratio covenant, the lenders may immediately cancel the loan agreements, deem the full amount of the outstanding indebtedness immediately due and payable; charge us interest on a monthly basis on the full amount of the outstanding indebtedness and, if we cannot repay all of our outstanding obligations, sell the assets pledged as collateral for the loans in order to fulfill our obligations to the lenders. We may also be held responsible for any damages and related expenses incurred by the lender as a result of any default. We entered into 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 us 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. On February 26, 2015, we entered into the Second Amendment to the Facility Agreement. The amendment extended the availability period for draws on the term loan facility from May 21, 2015 to July 31, 2015. It also allows us, upon the satisfaction of certain conditions, to designate from time to time one or more of Fabrinet’s subsidiaries as borrowers under the Facility Agreement. On July 31, 2015, we entered into the Third Amendment to the Facility Agreement. The amendment extended the availability period for draws on the term loan facility from July 31, 2015 to July 31, 2016. As of June 30, 2017, we had $36.4 million of long-term borrowing and $34.0 million of revolving borrowing outstanding under the Facility Agreement; as a result, there were available credit facilities of $116.0 million. In connection with our acquisition of Exception EMS, we assumed lease agreements for certain machine and equipment, which are accounted for as capital leases. As of June 30, 2017, we included approximately $1.9 million of capital lease assets and $1.4 million of capital lease liability in our consolidated balance sheets associated with these acquired lease agreements. As of June 30, 2017, we also had certain operating lease arrangements in which the lease payments are calculated using the straight-line method. Our rental expenses under these leases were $1.9 million, $1.2 million and $1.1 million for fiscal year 2017, fiscal year 2016 and fiscal year 2015, respectively. Capital Expenditures Our capital expenditures for fiscal year 2017, fiscal year 2016 and fiscal year 2015 principally related to investment in our new facilities in Thailand and the United States. During fiscal year 2017, we purchased equipment and entered into an agreement to purchase a parcel of land in Chonburi, to support the expansion of our manufacturing operations in Thailand. During fiscal year 2016, we purchased a parcel of land and began construction of our Chonburi campus. During fiscal year 2015, we purchased a building and associated land in Santa Clara, California. During fiscal year 2018, we expect to purchase additional equipment for our new manufacturing facilities in the United States and Thailand. Off-Balance Sheet Commitments and Arrangements As of June 30, 2017, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of SEC Regulation S-K. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Interest Rate Risk We had cash, cash equivalents, and marketable securities totaling $285.3 million, $284.5 million and $255.8 million, as of June 30, 2017, June 24, 2016 and June 26, 2015, respectively. We have interest rate risk exposure relating to the interest income generated by excess cash invested in highly liquid investments with maturities of three months or less from the original dates of purchase. The cash, cash equivalents, and marketable securities are held for working capital purposes. We have not used derivative financial instruments in our investment portfolio. We have not been exposed nor do we anticipate being exposed to material risks due to changes in market interest rates. Declines in interest rates, however, will reduce future investment income. If overall interest rates had declined by 10 basis points during fiscal year 2017, fiscal year 2016 and fiscal year 2015, our interest income would have decreased by approximately $0.3 million, $0.1 million and $0.1 million, respectively, assuming consistent investment levels. We also have interest rate risk exposure in movements in interest rates associated with our interest bearing liabilities. The interest bearing liabilities are denominated in U.S. dollars and the interest expense is based on the London Inter-Bank Offered Rate (LIBOR), plus an additional margin, depending on the lending institution. If the LIBOR had increased by 100 basis points during fiscal year 2017, fiscal year 2016 and fiscal year 2015, our interest expense would have increased by approximately $0.8 million, $0.1 million and $0.1 million, respectively, assuming consistent borrowing levels. We maintain an investment portfolio in a variety of financial instruments, including, but not limited to, U.S. government and agency bonds, corporate obligations, money market funds, asset-backed securities, and other investment-grade securities. The majority of these investments pay a fixed rate of interest. The securities in the investment portfolio are subject to market price risk due to changes in interest rates, perceived issuer creditworthiness, marketability, and other factors. These investments are classified as available-for-sale and, consequently, are recorded on our consolidated balance sheets at fair value with unrealized gains or losses reported as a separate component of shareholders’ equity. Investments in both fixed-rate and floating-rate interest earning instruments carry a degree of interest rate risk. The fair market values of our fixed-rate securities decline if interest rates rise, while floating-rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may be less than we expect because of changes in interest rates or we may suffer losses in principal if forced to sell securities that have experienced a decline in market value because of changes in interest rates. Foreign Currency Risk As a result of our foreign operations, we have significant expenses, assets and liabilities that are denominated in foreign currencies. Substantially all of our employees and most of our facilities are located in Thailand, the PRC and the United Kingdom. Therefore, a substantial portion of our payroll as well as certain other operating expenses are paid in Thai baht, RMB or GBP. The significant majority of our revenues are denominated in U.S. dollars because our customer contracts generally provide that our customers will pay us in U.S. dollars. As a consequence, our gross profit margins, operating results, profitability and cash flows are adversely impacted when the dollar depreciates relative to the Thai baht, GBP or the RMB. We have a particularly significant currency rate exposure to changes in the exchange rate between the Thai baht, GBP and the U.S. dollar. We must translate foreign currency-denominated results of operations, assets and liabilities for our foreign subsidiaries to U.S. dollars in our audited consolidated financial statements. Consequently, increases and decreases in the value of the U.S. dollar compared with such foreign currencies will affect our reported results of operations and the value of our assets and liabilities on our audited consolidated balance sheets, even if our results of operations or the value of those assets and liabilities has not changed in its original currency. These transactions could significantly affect the comparability of our results between financial periods or result in significant changes to the carrying value of our assets, liabilities and shareholders’ equity. We attempt to hedge against these exchange rate risks by entering into derivative instruments that are typically one to eighteen months in duration, leaving us exposed to longer term changes in exchange rates. During the year ended June 30, 2017. We recognized foreign exchange loss of $1.0 million, $1.6 million and $0.02 million in the consolidated statements of operations and comprehensive income during fiscal year 2017, fiscal year 2016 and fiscal year 2015, respectively. As foreign currency exchange rates fluctuate relative to the U.S. dollar, we expect to incur foreign currency translation adjustments and may incur foreign currency exchange losses. For example, a 10% weakening in the U.S. dollar against the Thai baht, the RMB and the GBP would have resulted in a decrease in our net dollar position of approximately $4.8 million and $2.3 million as of June 30, 2017 and June 24, 2016, respectively. We cannot give any assurance as to the effect that future changes in foreign currency rates will have on our consolidated financial position, operating results or cash flows. Credit Risk Credit risk refers to our exposures to financial institutions, suppliers and customers that have in the past and may in the future experience financial difficulty, particularly in light of recent conditions in the credit markets and the global economy. As of June 30, 2017 and June 24, 2016, our cash and cash equivalents were held in deposits and highly liquid investment products with maturities of three months or less with banks and other financial institutions having credit ratings of A minus or above. As of June 30, 2017 and June 24, 2016, our marketable securities were held in various financial institutions with a maturity limit not to exceed three years, and all securities were rated A1, P-1, F1, or better. We continue to monitor our surplus cash and consider investment in corporate and U.S. government debt as well as certain available-for-sale securities in accordance with our investment policy. We generally monitor the financial performance of our suppliers and customers, as well as other factors that may affect their access to capital and liquidity. Presently, we believe that we will not incur material losses due to our exposures to such credit risk.