The Art of Becoming Flexible
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In May I initiated coverage on Flextronics (NASDAQ: FLEX) noting that the Singaporean lean manufacturer was in the process of re-tooling their entire business away from being a high turnover, low-margin short product life-cycle outsourcing assembler into a more diversified higher margin primary manufacturer. Given the ongoing implosion of one of their former main clients, Research in Motion (NASDAQ: BBRY), that strategy not only seems prescient but eminently practical.
Management’s goal in the face of purposefully allowing their formerly biggest revenue stream to be pruned down via attrition was to allow revenues to retreat but margins to rise while other manufacturing verticals matured. Reporting their 2nd quarter earnings earlier in the week it is safe to say that management has been executing that plan to a tee without setting unrealistic goals or giving overly-optimistic guidance.
Going through the results via the conference call from this past quarter the breakdowns are a mixed bag with the INS (Integrated Networking Solutions) vertical seeing both sequential and year over year contraction. In effect there has been no growth there for the past five quarters and accounts for 46% of revenue. Considering Flextronics is one of Cisco Systems (NASDAQ: CSCO) biggest suppliers this result should not be unexpected.
Industrial and Emerging Industries (IES) also had a difficult year in terms of revenue growth down 10% year over year, but 7% growth sequentially. While the High Reliability Solutions (HRS) vertical posted strong growth at 7% compared to last quarter and 20% year over year. This is Flextronics smallest business but its highest margin with products concentrated in both automotive and medical, having much longer life cycles. This focus puts a lot less capital at risk of going unused, creates a lot more certainty and predictability and moves them into industries not so dependent on consumer cycles.
This was expected to be a dismal quarter in terms of revenue. This plan, much like the reorganization plans at Microsoft and Cisco, was set in motion knowing it was a risk from an IR perspective. The flip side of it is that they easily beat earnings consensus as gross and net margins have increased for 3 consecutive quarters and while guidance for Q3 was very conservative given the global economic situation they are projecting margins to continue to improve in the face of it.
The net result is that, in the short term their cash flow is unencumbered by debt maturity, with just $177 million in payments needed before CY 2014 while they have $2.5 billion on hand so there is no medium term erosion of shareholder equity on the horizon.
The short term revenue outlook is flat, including in HRS, but the future is bright with more than $2 billion in booked business that has a longer lead time. This is much stickier business with automotive and medical companies far less likely to ditch their OEM’s than in consumer electronics because of the larger QA and regulatory hurdle associated with supplying those markets.
With economic conditions deteriorating around the world, Flextronics goals of a 25% ROIC versus a WACC of 8.5% and 4% operating margins may be farther off than they initially forecast, but they are having no problem shifting into new markets. ROIC slipped this quarter to 20.1% and net margins increased from 2.7% to 3% with guidance to between 3% and 3.3% for next quarter.
This is a company with nearly unparalleled employee retention statistics, management that understands the costs of IP leakage on their customer retention as well as the futility of trying to compete with the FOXCONN’s of the world. Trading at a multiple of 9 without a dividend yield, a low debt to equity ratio and what looks like the worst to be behind them in terms of top line shrinkage, Flextronics looks attractive in the long term.
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