Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message| ()  

Flextronics International Ltd. (FLEX)

F1Q07 Earnings Conference Call

July 25, 2006 4:30 pm ET

Executives

Mike McNamara - CEO

Tom Smach - CFO

Analysts

Bernie Mahon – Morgan Stanley

Todd Coupland – CIBC World Markets

Alex Blanton – Ingalls & Snyder, LLC

Carter Shoop – Deutsche Bank

Lou Miscioscia – Cowen & Co.

Jim Suva - Citigroup

Kevin Kessel – Bear Stearns

Steven Fox – Merrill Lynch

Thomas Dinges - J.P. Morgan

Michael Walker - CSFB

Brian White – Jefferies & Co.

Matt Sharon – Thomas Weisel Partners

Yuri Krapivin - Lehman Brothers

Operator

Good afternoon and welcome to the Flextronics first quarter earnings conference call. (Operator instructions) I would like to turn the call over to Mr. Mike McNamara, Chief Executive Officer. Thank you, sir. You may begin.

Presentation

Mike McNamara

Ladies and gentlemen, thank you for joining the conference call to discuss the results of Flextronics first quarter ended June 30, 2006. To help communicate the data in this call, you can also view our presentation on the Internet. Go to the Investor section of our web site and select Calls and Presentations. You will need to click through the slides. We will give you the slide number we’re referring to.

On the call with me today is our Chief Financial Officer, Tom Smach. I will turn the first part of the call over to Tom to go through the financial portion of our prepared remarks. I will then provide some commentary along with our guidance for next quarter and the current fiscal year, and then open it up to questions.

Before I turn the call over to Tom, there’s one housekeeping item to cover. We are planning on hosting an analysts’ day in New York City in the afternoon of October 26. Additional details will be sent out when finalized but in the meantime, please save the date.

Go ahead, Tom.

Tom Smach

Thanks, Mike, and good afternoon, ladies and gentlemen. We’re on Slide 2. Please note that this conference call contains forward-looking statements within the meaning of the federal securities laws, including statements related to potential growth opportunities in our core EMS business, the success of our market-focused approach and our vertical integration and accelerated growth strategies, revenues and earnings growth, the success of our long-term initiatives and related capital expenditures, a proposed divestiture of our software development and solutions business, and the expected gain and returns from the divesture, new customer opportunities, profitability and anticipated use of available cash.

These statements are subject risks that can cause actual results to differ materially. Information about these risks is noted in the earnings press release on Slide 16 of this presentation, and in the risk factors and [NV&A] sections of our latest annual report filed with the SEC, as well as in our other SEC filings.

These forward-looking statements are based on our current expectations and we assume no obligation to update these forward-looking statements. Investors are cautioned not place undue reliance on these forward-looking statements.

In addition, throughout this conference call we will use non GAAP financial measures. Please refer to the schedules, the earnings press release, Slide 8 of the slide presentation and the GAAP versus Non-GAAP Reconciliation in the Investor section of our web site, which contains the reconciliation to the most directly comparable GAAP measures.

Slide 3. Revenue from continuing operations in the June quarter was $4.1 billion, an increase of 6% or $236 million over the year ago quarter. Revenue for the core EMS business, which excludes software, semiconductor and network services increased by $422 million, or 12% from $3.6 billion in the year ago quarter. On a sequential basis, revenue from continuing operations grew $528 million, or 15%, and exceeded our previously communicated guidance for this quarter.

Slide 4. As discussed on the last couple of calls, our strategy is to accelerate revenue growth and enhance profitability in the core EMS business by organizing resources to a market-focused approach. This is designed to bring more value and innovation to customers, improve our competitiveness and to increase market share with customers. As a result, senior executives have been added from the outside or promoted internally to lead each segment.

Beginning with the June quarter, we have changed the market segments in which some of our products are classified, as illustrated by this slide.

Slide 5. The information from prior periods shown on this slide has been revised to conform to the new market segment categories as shown in Slide 4. Imputing increased by $63 million sequentially and represents 15% of total June quarter revenue. Consumer digital increased by $111 million sequentially and represents 22% of the total June quarter revenue. Infrastructure increased by $105 million sequentially, and represents 25% of total quarterly revenue. Mobile increased $188 million sequentially and represents $28 million of total June quarter revenue. Industrial, Automotive, Medical and Other increased by $61 million sequentially and represents 10% of total June quarter revenue. Sony Erickson, Hewlett-Packard, and Nortel all individually exceeded 10% of total revenue in the June quarter. Our top ten customers accounted for approximately 65% of revenue in the quarter.

On a geographical basis, Asia increased on a sequential basis to 59% of total revenue while Americas decreased to 22% and Europe decreased to 19%.

Slide 6. On a sequential basis, gross margin decreased 20 basis points to 5.8%, SG&A as a percentage of sales decreased 30 basis points to 2.8%, and operating margins improved 20 basis points, to 3.1%.

Slide 7. Excluding amortization, restructuring and other charges including stock-based compensation, quarterly net income amounted to $104 million. This resulted in earnings of $0.18 per diluted share in the current quarter compared to $0.17 in the year ago quarter.

Slide 8. After tax amortization, restructuring and other charges amounted to $19 million in the current quarter compared to $41 million in the year ago quarter. It is important to note that effective April 1, other charges include stock-based compensation expense of $7.4 million in the June 2006 quarter. There were no restructuring charges for the current quarter.

After reflecting these charges, GAAP net income for the current quarter amounted to $85 million compared to $59 million in the year ago quarter. This resulted in earnings of $0.14 per diluted share in the current quarter compared to $0.10 in the year ago quarter.

Slide 9. Return on investment on tangible capital improved to 30% from 26% in the year ago quarter, while return on invested capital has improved to 10% from 9% in the year ago quarter.

Slide 10. We ended the quarter with $886 million in cash, up from $830 million at June 30, 2005, while total debt has increased by $22 million since that time. Including our revolver availability, total liquidity was in excess of $2 billion and debt to total capital ration was 25% at quarter end.

Slide 11. Cash conversion cycle came in at an industry leading 12 days, versus 20 days for the year ago quarter. Important to note that $175 million of the sequential increase in our inventory balances is attributable to the acquisition of the Nortel Calgary facility in May 2006.

Slide 12. In the June quarter depreciation and amortization amounted to $81 million and net capital expenditures were $82 million. Cash flow from operations used $98 million in the current quarter.

Slide 13. As previously announced, we’ve entered into a definitive agreement to sell our software business to KKR in a transaction valued at approximately $900 million. Upon closing, Flextronics expects to receive in excess of $600 million in cash and will hold a $250 million face note with a 10.5% paid in kind interest coupon which matures in eight years. Flextronics will also retain a 15% equity stake in the business. The gain on sale is expected to approximately $150 million. This transaction is expected to close during the September quarter and we will update you on the specific impact on our balance sheet and income statement at that time. Once the transaction closes, net income from discontinued operations will cease and is replaced by interest income on the PIK note and the investment returns on the cash proceeds.

Thank you very much, ladies and gentlemen. As you turn to Slide 14, I will now turn the call over to Mike McNamara.

Mike McNamara

Thank you, Tom. Before discussing guidance, I would like to take a few minutes to reflect on the results of our quarter and our outlook.

As we have stated many times, we believe there has been a re-acceleration of significant growth opportunities in our core EMS business which includes design, vertically integrated manufacturing services, components and logistics. Fiscal 2006 was a very strong year in terms of incremental business wins from both new and existing customers. As a result, we exceeded revenue and earnings expectation in the June quarter. I think you should begin seeing even higher revenue growth rates in the second half of calendar 2006.

We continue to make considerable investments to support the growth in our core EMS business. The ability to provide vertically integrated EMS services from our industrial parks remains a big competitive advantage for Flextronics. We remain firmly committed to the concept of vertical integration and the competitive advantages we will realize from it.

We are continuing to add manufacturing capacity in China, India, Malaysia, Ukraine, Brazil and Mexico to enhance our position and competitiveness in the marketplace.

Multek’s printer circuit board operation continues to perform very well. Multek is expanding its rigid circuit capacity in China with two new factories that we expect to come online by the December 2006 quarter. The new flexible circuit factory in China is beginning volume production ramp in the September quarter.

Obviously we’re making significant investments in our future. We expect Capex to be in the range of $450 million and depreciation to be approximately $325 million in Fiscal 2007. We think these investments will not only help us meet our revenue growth expectations while yielding better profits and returns for shareholders, but we will also improve our competitiveness and enhance our capabilities.

As a result of focusing on our efforts and resources on improving the customer’s overall profitability and the significant growth opportunities in the core EMS business, we divested the network services and semiconductor businesses and have a definitive agreement to sell the software business. By monetizing these non core assets at substantial gains over carrying value, Flextronics will have generated cash proceeds in excess of $1 billion, assuming the software transaction closes as expected this summer. These proceeds provide necessary funds to support our accelerated growth strategy.

Other substantial benefits from these divestitures include $135 million of deferred tax assets and a $1 billion reduction in goodwill and intangibles, which significantly increases the company’s tangible equity and therefore enhances our financial position.

In addition, we will have retained ownership interests in both the software and network services business, which should provide additional cash and potential future upside when monetized.

Slide 15. For September 2006 quarter we are currently expecting revenue from continued operations to grow 25% to 30% on a year over year basis, in the range of $4.7 billion to $4.9 billion and earnings per share to grow 10% to 25% on a year over year basis in the range of $0.19 to $0.21 per diluted share.

We have typically provided guidance for only one quarter at a time however we will change that policy today in order for people to better understand our fiscal growth rate expectations.

For the fiscal year ended March 31, 2007, we are currently expecting revenue from continuing operations to grow somewhere in the range of 25% on a year over year basis to approximately $19 billion and EPS to grow in the range of 15% on a year over year basis to approximately $0.80 per diluted share. Obviously there is a range around these numbers and we urge you to be conservative as the economy and demand trends are dynamic.

GAAP earnings per diluted share are expected to be lower than the guidance provided herein by approximately $0.03 per diluted share per quarter for quarterly intangible amortization expense and stock-based compensation expense. In addition, our guidance does not include the gain on the disposition of software net of charges.

Slide 16. There are real risks or operating this business which include the macroeconomic or technology slowdown, among other things. Please pay particular attention to this slide in light of the current market conditions.

I will now turn the conference call over to the Operator for questions. Please limit yourself to one question and one follow-up.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Bernie Mahon of Morgan Stanley.

Bernie Mahon – Morgan Stanley

Hi, good afternoon.

Mike McNamara

Good afternoon.

Bernie Mahon – Morgan Stanley

Question for you on the demand trends. It’s just a little confusing, the way that you reclassified so I was just wondering, you know, you were up $200 million versus kind of the mid point of your guidance. Your results came in better. Could you kind of break that out? How much of that was from closing Nortel a little bit earlier versus where you saw, like what end mark that you saw the upturn in demand?

Tom Smach

That’s kind of a tough question. You know, Nortel pretty much happened as expected so I think, you know, we kind of anticipated the numbers that did come in for Nortel so I don’t think there was much of a trend there. Mobile had the biggest jump of $188 million. I think it was $188 million, right? Yep. I mean, $188 million, which was the biggest jump in terms of total dollars so a lot of our cell phone customers had that as well during the quarter.

But if you look at, you know, across the sequential growth in each of the different seven segments which we itemize, like, I think each and every one of them was up pretty significantly and pretty evenly. So it’s really a broad-based, kind of a well-diversified increase across all of our market segments.

Bernie Mahon – Morgan Stanley

Okay. And then when you look out to the September quarter, I mean, obviously the revenue guidance there is, you know, a little bit stronger than what most people had anticipated. Where are you seeing that strength? Is that broad-based or is that more ramping a consumer program, or what are you seeing there?

Tom Smach

Yeah, we see a lot of the same things. You’ll get some products that are very traditionally the seasonally ramping products so, things like mobile and, you know, also the printer kind of products that we typically see very season activities. But we actually again next quarter expect, you know, each of the different categories to grow and expand so we would again expect it, you know, outside of the normal seasonality of kind of the usual product categories, we also expect a continuing broad-based, you know, well-diversified growth across all segments.

Bernie Mahon – Morgan Stanley

Okay. Thanks a lot.

Operator

Our next question comes from Todd Coupland of CIBC World Markets.

Todd Coupland – CIBC World Markets

Yeah. Good morning, or good afternoon.

Mike McNamara

Good afternoon.

Todd Coupland – CIBC World Markets

I wondering if you’d just talk a little bit about the difference in the spread between the revenue growth that you expect in those seven and the EPS growth, and wondering how you expect that to profile over the course of the year? I guess I would have thought, with that type of revenue growth, you might have seen stronger EPS growth. Just talk us through that. Thanks.

Tom Smach

Yes, the one thing is it, you know, tends to be somewhat dependent on the different kind of products that we would be booking. You know, some products are going to have a little bit higher revenue and earnings per share and some are going to be a little bit lower and it really is a function of the asset turns associated with those programs.

So, you know, outside of the mix issue, the real key is start up costs more than anything else. The fact that we are ramping as rapidly as we are has caused us to accelerate a lot of the building investments that we’re doing around the world. It’s caused us to accelerate the amount of equipment that we’ve got coming in place and the amount of people we’re hiring right now is at a pretty fierce rate. So between all those things, actually the accelerated growth puts a little bit of a damper and a downturn on the earnings as a result of these start-up costs. If the growth rates were more moderate, you know, those start-up costs would be absorbed but the fact that we’re growing, you know, upwards of 25% is going to make it a little more challenging for us to completely absorb those start-up costs.

So we will expect that to take down the margin slightly, you know, although not much but it kind of explains the earnings per share mismatch with revenue growth, and then we’d expect to catch up on it next year.

Todd Coupland – CIBC World Markets

So would you expect the new program costs to impact results fairly equally throughout the year and then it’s an 08 leverage story?

Tom Smach

Yes. So I think what you’ll see is you’ll see, you know, March have the usual seasonality down and then I think once you hit June we’ll be back, you know, at pretty normal levels and hopefully, you know, achievement better than 3% operating margins at that point.

Todd Coupland – CIBC World Markets

Okay, great. Thank you very much.

Operator

Our next question is from Alex Blanton of Ingalls & Snyder.

Alex Blanton – Ingalls & Snyder, LLC

Good afternoon.

Tom Smach

Hi.

Alex Blanton – Ingalls & Snyder, LLC

Just pushing a few numbers, the next nine months if you make the $19.1 billion which represents a 25% increase, would be just over $15 billion, or about a 32% increase from last year’s similar period of nine months. So that’s an average of about $5 billion a quarter. Could you give us some idea of what’s in there? What is responsible for the increase? What kinds of products? What kinds of new business you might have won that would be in there and so on?

Tom Smach

Well, we’ve made some announcements of new business which will –

Alex Blanton – Ingalls & Snyder, LLC

Yes.

Tom Smach

Somewhat and, you know, beyond that, we either don’t have authorization from the customer or maybe it’s just existing customers that we’re ramping. The biggest element again is going to be mobile phones. We’ve grown that substantially year on year. We’ll achieve growth rates that could be as high as 40% or 50% on a year over year basis.

Alex Blanton – Ingalls & Snyder, LLC

For the whole year, or for just the next nine months.

Tom Smach

Yeah. I mean, year over year. I didn’t look at the nine months.

Alex Blanton – Ingalls & Snyder, LLC

Okay.

Tom Smach

But that’s a huge part of it. We’re having a lot of success in the phone business and we also have, you know, pretty good traction in our ODM business, as we talked about before. So, you know, that business is growing on all fronts. You know, we also have the Nortel business which is at full ramp this year as opposed to last year, where all the factories are now transitioned to cross so that’s also pretty significant.

But again we anticipate, you know, as a result of these seven markets we’re going after that each and every one of them will have solid growth and I don’t think there’s any one of those markets that we don’t anticipate double-digit growth in.

Alex Blanton – Ingalls & Snyder, LLC

Okay. Is any of the Lego business in there?

Tom Smach

Yes. But probably – I mean, not a huge number.

Alex Blanton – Ingalls & Snyder, LLC

When does that start?

Tom Smach

Some of it started already, so it’s going to end up being, you know, probably on an 18 month kind of ramp plan but our first shipment for Lego was probably, we may have even had a few shipments in June, but substantially they’re starting this quarter.

Alex Blanton – Ingalls & Snyder, LLC

Okay, and is there any new set top box business in there?

Tom Smach

Yes. Quite a bit.

Alex Blanton – Ingalls & Snyder, LLC

Can you say anything about that? Where that came from?

Tom Smach

No.

Alex Blanton – Ingalls & Snyder, LLC

No. Okay.

Tom Smach

Sorry about that. We need to check with the customer on that so we – but, yeah, there’s some more set top box business in there.

Alex Blanton – Ingalls & Snyder, LLC

Okay. Thank you.

Operator

Our next question is from Carter Shoop of Deutsche Bank.

Carter Shoop – Deutsche Bank

Great. Thanks. Wanted to touch on the inventory and then also the pricing environment. First on inventory, Nortel closed relatively early in the quarter so I figured that wouldn’t be too much of a drag. What are your expectations now that we’ve seen inventory philosophy come down quite a bit? Can we expect to see inventory churn start to increase throughout the remainder of the year, or do you expect them to kind of stay where they are now?

Tom Smach

Yeah, we actually probably anticipate them to stay pretty flat. So the impacts of inventory right now are, you know, as we mentioned, $175 million with Nortel but that comes with real low turns as that’s being transitioned over and the vertical integration kind of aggravates that a little bit.

The other key is that we’re ramping and we’re growing pretty substantially so between those two effects, I actually think it’s going to be roughly the same as it is now and then I would expect to make, again, meaningful contributions to that probably as we come out of the March quarter and into June of next year.

Carter Shoop – Deutsche Bank

Okay, and then the second question is on the pricing environment in the industry. Can you comment on that? Has that changed at all the past three to six months?

Tom Smach

I don’t think so. It’s the same, it’s the same – it’s a tough, it’s a competitive environment and you just need a lot of tools to be able to compete in it and – but I don’t think it gets any harder or any easier as – I think it’s about the same.

Carter Shoop – Deutsche Bank

Thanks.

Operator

Our next question is from Lou Miscioscia of Cowen & Co.

Lou Miscioscia – Cowen & Co.

Okay. Thank you. Mike, if you could go back to, I guess the analyst meeting in May of last year, and just sort of see if we could slice this a different way. You guys talked, I guess, about $4 billion of business that you won. Obviously seems like now some of it’s obviously hitting in, coming in. I think the main categories you talked about were servers, cell phones, printers and then other, probably it was like more in the industrial category. Is it still that same business that you talked about back then that you’re talking about that’s ramping up now, or is there other things that have come in and other things maybe that, you know, maybe fell off.

Mike McNamara

Yeah. Yeah, I think if you look across that group I would say cell phones are, you know, relative to expectations last May. You know, it’s – you know, cell phones are very, very strong so they’ve come through as anticipated and our programs have held up pretty nicely, that we’ve gotten the designs on.

Servers and printers I would say are substantially below original expectations so while there’s some in there today, I would say, you know, what we originally communicated in terms of how big those programs are, you know, as a bundle are probably no more than half of what we anticipated.

We kind of mentioned one of the problems with getting so involved so early in the cycle is you get certain indications of what those programs might look like and you’re so far in the beginning of the cycle and in the middle of the design cycle, it’s really hard to have reliability to those.

So I would say, you know, those are half of expectations so a lot of what you’re seeing as a result are a lot of new things that have kicked in, or market share increases with the existing customers or just some of our customers having good success in the marketplace.

Lou Miscioscia – Cowen & Co.

Okay. That’s actually helpful. Let me go back to the demand question one more time. Just from any organic demand with your customers, obviously it looked like numbers were pretty good here and you are getting positive seasonality, but would you characterize as we go into the summer months here that, in general, demand is about where you expected or do you think that tech is weakening or on the other end, do you think it’s actually strengthening as we go into, I guess the September quarter here.

Mike McNamara

Yeah, I don’t, I don’t – you know, looking across the whole base, I don’t know that we see it strengthening or weakening, either one. We’ve had pretty solid demand trends through the first half of the year we thought, and it seems they’re maintaining those pretty solid demand trends through the back half of the year. So I think relative to overall macro demand, I think we’re pretty much on target for what our expectations were and [thus] they’re pretty steady growth.

Lou Miscioscia – Cowen & Co.

Okay, thank you. Good luck with the job ahead.

Mike McNamara

Thanks.

Operator

Our next question is from Jim Suva, Citigroup.

Jim Suva - Citigroup

Great, thank you and congratulations. Can you give us a little bit of an update on the traction you’re getting on your vertical model, kind of the PCB and the enclosures in that business? One of your competitors is having a little bit of difficulty. Maybe let us know kind of where you’re at, the traction you’re getting in with some of the Capex. Are you doing anything new in these areas?

Tom Smach

Well, we brought on the – you know, in terms of what we have new, so we’ve brought on the flex circuit assembly business. That’s a new business for us that we’ve not participated in, in the past. You know, basically the metal demand is solid; we see no decreases. We’ve actually got our first, you know, potentially our first [word] to go into India with metal that we’re looking forward to, which we’ve not had in the past. We are adding, we’ll be adding plastics capability quite substantially. A lot of that is just our core business keeps going up, our cell phone plastics keep going up and also the Lego business itself adds capacity to plastics very significantly.

You know, I’d say we’re going to – I don’t know, metal in amongst itself, how much that’s going up but, you know, plastics is probably going to up close to 50% over an 18 month timeframe and I suspect metal is up, you know, well into the double-digits so we’re expanding capacity there pretty substantially.

So, you know, we always see the trends as being pretty solid. Those trends kind of go along with our overall revenue growth rates because typically we sell multiple, you know, multiple verticals simultaneously with the customer so the tend to go hand in hand.

Jim Suva - Citigroup

Great. Thank you, and as a follow-up, can you touch up on the status you’ve had with the [Rojas] transition with you and your customers and is it pretty much, I mean, bumps taken care of or have we still got a few more programs transitioning over?

Mike McNamara

You know, we think we’re pretty much intact on the [inaudible]. We’ve tracked each one of our different factories. We track the, what we have that’s a certain amount of compliance that each site is required to have. We’re at virtually 100% compliance for each one of those sites. We’ve been working with our customers a lot. We’re not anticipating inventory impacts or end of life inventory. I mean, there probably will be some but we expect it to be very, very minor.

You know, in all I think the program management that we’ve done over this program and the working with the customers and the proactivity that we’ve, you know, we’ve encountered has been very strong and we’re pretty positive on this not creating an issue and our readiness for our customers, we think, is exceptional.

Jim Suva - Citigroup

Great. Thank you and congratulations.

Mike McNamara

Thanks.

Operator

Our next question is from Kevin Kessel of Bear Stearns.

Kevin Kessel – Bear Stearns

Hi, good afternoon. Just a question, Mike, on what you were talking about last quarter in terms of the profitability in the ODM business. I think you guys were expecting that to become breakeven and then profitable here in Fiscal 07 and the same in terms of the camera modules. I was expecting maybe that to have more of a leverage impact in terms of your EPS. Can you talk to that?

Mike McNamara

Yeah, keep in mind the ODM business we were losing some money and we were kind of breakeven and the camera modules, and what we anticipated about now, you know, for the second half of the year we anticipated both those turning profitable.

You know, alternatively we didn’t anticipate camera modules being anything more than EMS averages, which is what we talked about. So the impact is not enormous.

You know, and part of those benefits, you know, are really making [it subset], the start-up costs we’re incurring going through this 25% growth, be actually mitigated somewhat.

So I think, you know, they’re pretty much on track, both the ODM and the camera modules. You know, I think it’s mitigating what would have been even potentially higher start-up costs of the other business but we weren’t anticipating nearly breakthrough years this year but we were actually expecting this to be a transition year for both the ODM and the camera modules.

So, you know, to the extent that we actually accomplished our transition year, we would expect a nice margin impact next year, because that’s when we would expect to be fully profitable for the entire year and not be in a transition year. That’s our expectation.

Kevin Kessel – Bear Stearns

Okay, and then maybe this question’s for Tom. Tom, in terms of stock option expense, I think this was the first quarter you guys expensed stock options. Can you give us a sense of where you expect stock option expense to be for a full year basis, and then just talk in terms of the recent stock option backdating discussions. I think you know your name has come up maybe once, and then looking at your, some of your grants back in the 2000/2001 timeframe, maybe you can just refer to, you know, in terms of what the policy and procedures were and if anything’s changed.

Tom Smach

Yeah, so in terms of the first part, Kevin, our stock option expense was $7.4 million in the current quarter. I would annualize that to maybe around $30 million for the year. So, you know, more or less flat. We’ll grant some new options along the way but it’ll be about $30 million for the year.

With regard to the other issue you mentioned, I’m actually not really aware of any identification by any analyst or research firm or financial process as having unusual grant practices. We certainly have not been contacted by any regulatory authority as far as I know and I think I would know, and we’re not aware of any improprieties in our past stock option practices. We have not conducted an investigation so I really can’t comment on any specific grants in the past or anything like that. But to our knowledge, we’re not aware of any issues in our past practices.

Kevin Kessel – Bear Stearns

Okay, and then just speaking of your interest expense, I think that, and other, that came in quite a bit higher -

Tom Smach

Yes.

Kevin Kessel – Bear Stearns

- than I was expecting. Can you talk to that and why it was up so much on a sequential basis? Where you expect it to be going forward in your guidance?

Tom Smach

Yeah, it was definitely up more than we had expected as well, Kevin. Interest rates are going up and on a sequential basis, I think was up about $8 million. Half of that is strictly due to interest rates and higher average balances of the revolver during the quarter. We do use the revolver during the quarter.

Then the other half was losses on foreign currency transactions. The U.S. dollar exchange rate was pretty volative during the quarter so we incurred about a $4 million loss on FX transactions.

Kevin Kessel – Bear Stearns

Okay. Thank you.

Tom Smach

Yep.

Operator

Our next question is from Steven Fox of Merrill Lynch.

Steven Fox – Merrill Lynch

Hi. Good afternoon. Going back to the handset business, last quarter you talked about $5 billion plus in sales, 17 new ODM wins. Has there been any change in either the number of wins that you’re going to be ramping up this year or what type of revenues you’re looking for from handsets for the full year?

Mike McNamara

Yeah, the wins that actually hit revenue this year I would say, not. They take some time to fall in and all the new wins that we get this year are really going into next year so –

Steven Fox – Merrill Lynch

For ODM, you’re taking about.

Mike McNamara

For ODM.

Steven Fox – Merrill Lynch

Yep.

Mike McNamara

So I think that’s pretty much on track. We described last time, we also anticipated a pretty substantial increase next year. We think that’s on track. So the design wins are coming in for next year as anticipated so we feel we’re pretty much on track there, not above or below, just on track. We think the overall mobile phone business is probably coming in higher than anticipated, so that’s actually a little bit above expectations and tends to creep up a little bit, you know, every quarter for the last couple of quarters. So we’re, you know, anticipating that business to even be over $5 billion this year.

Steven Fox – Merrill Lynch

Okay, and then in terms of just getting some more leverage, you mentioned that some of the start-up costs are hurting you in Fiscal 07 and that you could get some of that back in Fiscal 08 and see some leverage, but theoretically, you’d still be getting wins in Fiscal 08 so I’m just curious what would, why won’t those start-up costs from successive wins hurt leverage in Fiscal 08? Is there something specific in 07 going on?

Mike McNamara

Yeah, Steve, so it’s just the inflexion of the growth rate, right? So we basically – our revenues have been flattish for the last three years and now we have hit the step function where we’re going from a zero percent growth rate to a 25% to 30% growth rate, and there’s an enormous amount of start-up costs associated with that.

So as the growth rate steps up, our start-up expense likewise is stepped up, in fact, the start-up expenses are incurred before the growth actually occurs. So the growth lags the start-up costs.

So what will happen next year is, if the growth rate flattens out or reduces, then your start-up costs are going to flatten out, be consistent or reduce along with the growth rate. So that’s where the earnings leverage is. However, if our growth rate is higher next year than what we expect this year, then our incremental start-up costs would be higher. So it’s just a function of the growth rate.

Steven Fox – Merrill Lynch

Okay.

Mike McNamara

And then once – the other thing that lags the growth rate is vertical integration so, you know, we transfer over EMS business that immediately contributes to higher growth rates and then over time we work in vertical integration sometimes. So there is a lag effect to both vertical integration and those start-up costs in terms of driving higher margins.

So we do think it’s a function of the growth rate. EPS is not deteriorating, obviously. We think we’ve made a conscious decision to grow that top line to drive higher earnings, higher earnings dollars, and then once that growth rate flattens out, then we will go to work on the earnings leverage to get those margins to start improving as well.

Steven Fox – Merrill Lynch

Okay. Fair enough. Thank you very much.

Operator

Our next question is from Thomas Dinges of J.P. Morgan.

Thomas Dinges - J.P. Morgan

Hi. Question for Tom. Tom, last year as you looked at the operating expense line and the progression that you guys saw there, you did a nice job starting off the year at kind of a peak and reaching a trough in the fourth quarter and obviously inherent in leverage is both gross margin improvement but also is some leverage off the op ex and kind of, what’s the expectation there? Because I would assume that most of the major hiring that you guys are doing is in lower- cost regions and that would include, you know, both former employees that go in the COGS line but also the overhead and support that probably goes on the SG&A line.

Tom Smach

Yeah, you’re exactly right, which I should have mentioned so I’m glad you brought that up.

The other thing that occurs with the higher revenue is the leverage on the SG&A side so the SG&A dollars do not grow in proportion to the revenue growth. So you’re going to see that SG&A expense come down as the revenues continue to grow.

So short-term product mix and start-up costs are going to [press] your gross margins but you’re going to pick up a lot of that in back of the SG&A line as SG&A as a percentage of sales will lever down, because we do have very tight spending controls, as you pointed out.

So while SG&A dollars will grow a little bit, the percentage as a percentage of sales will come down and that’s why we think we can hold operating margins at around 3%, you know, plus or minus a little bit. But that’s the objective is to go through this high growth rate while holding operating margins around flat.

Thomas Dinges - J.P. Morgan

Then just two quick housekeeping items. One, I didn’t catch it if you gave it, but tax rate expectations for the full year. Has that now ratcheted down to kind of around where you guys reported this quarter or I think we were thinking somewhere between 5 and 10 for the year before, and it seemed like maybe the lower end of that?

And then also, in the outlook for next quarter, are you also expecting, does that include a couple of pennies like it did this quarter from the divested ops?

Tom Smach

So, the question – so, our earnings guidance for next quarter certainly includes any earnings from the divested ops, you know, up until the day that they’re disposed of. Now, after that transaction closes, the income from discontinued operations will be replaced with interest income and the investment proceeds on how we utilize the cash. So we think that, you know, the lower net interest will offset the loss of income from discontinued operations, so it will just be more reclassification than anything else.

With regard to the tax rate, we’re still projecting a 7% to 10% tax rate for the year. In the first quarter it is a little confusing because of discontinued operations but if you were to breakout pre-tax income from discontinued operations along with continuing operations, our first quarter tax rate was 7% and it’s hard to see that because discontinued operations has some tax expenses imbedded in that line as well. But for the first quarter it was around 7% and for the year we continue to project 7% to 10%.

Thomas Dinges - J.P. Morgan

Okay. Thank you.

Tom Smach

Thank you.

Operator

Our next question is from Michael Walker of CSFB.

Michael Walker - CSFB

Thanks. Just one question left, which is on cash flow. You know, obviously you’re going into a growth phase here. The preliminary results, i.e., the first quarter’s worth of the growth, shows that inventories look to be growing at about the same rate as revenues. You’re going to have cash consumed there. Margins are under pressure a little bit from the ramp so my question is, you know, are we probably looking at a negative cash flow year or do you expect that to revert to positive in the second half of the year and what’s the long-term strategy on that front?

Tom Smach

So for the year, Mike, again going from a step function of the growth rate, from zero percent last year to 25%, 30% this year, as you pointed out working capital is going to be required to fund that growth. So I think cash flow from operating activities we expect to be around neutral. We don’t expect it to consume or provide any cash.

And then longer term, again, it’s just a function of the growth rate. If we level out, growing somewhere between 20% and 30% on a longer-term basis, then most definitely you could expect positive cash flow from operating activities.

Michael Walker - CSFB

Okay, and just –

Tom Smach

It’s just this growth – step function of the growth rate that’s going to consume capital to fund the growth.

Michael Walker - CSFB

Okay, and just a follow-up question on inventory specifically. It looks like you’ve ramped inventories in accordance with the revenue growth you expect to have next quarter and I think earlier you said you expect churns to kind of hang in about the same over the course of the year. Are you seeing customers sort of change their strategy with regard to how the EMS companies are handling inventories? You know, [inaudible] go to the customer but Cisco’s obviously very publicly shifting inventories onto EMS balance sheets. Is that something that you’re seeing play out with other customers at all? Is there a secular change going on?

Tom Smach

Yeah, I think it’s been a trend that’s been going on for years, to be honest with you but the responsibility of the, kind of your inventory as it feeds your customer, it’s more and more popular that becomes your responsibility. Which I guess Cisco [inaudible]. We’re more and more – and that is one of the issues that we have in terms of inventory turns and ramping new programs. A lot of times we have to feed the pipe and the pipe being the raw material, the work in process in the factory and very often we have to have a hub, you know, right in front of the point of use for our customers.

So I think that’s – I actually don’t think that’s that new. I think it’s been kind of a long-term trend. You know, maybe there’s a little bit of acceleration on it recently but I just think it’s part of a long-term trend that’s been going on for awhile.

You know, it [doesn’t] create a fundamental shift and, you know, our objective is just to push this right on back in the same way for the companies that supply us products. We need to go push that back into them and just kind of have it flow right out through the supply chain, which is just a more efficient use of capital by pushing it all the way back to the beginning of the chain.

So, you know, as our customers do it, you know, we just do it a little bit more aggressively. We tend to get a bit of a lag because it’s kind of easy for our customers to do it because there’s just one of us and a lot of times we have to go to hundreds of suppliers or a couple hundred suppliers and go work the programs individually.

So the time that – when those programs are implemented, it actually takes us longer to catch up. But fundamentally we do expect to improve turns over time; not this year, but we do expect improved turns over time and expect to catch that in due course. So I actually don’t think there’s that fundamental of a difference in the amount of inventory we’re going to carry over time. Maybe a little bit.

Michael Walker - CSFB

Thanks a lot.

Tom Smach

I want to clarify, and emphasize one thing on your actual question. I said operating activities would be neutral, which means earnings, depreciation, amortization will offset working capital used to fund the growth. Now, free cash flow which is after Capex would mean that we’re going to be negative $450 million on a free cash flow basis, after paying for Capex.

Michael Walker - CSFB

Okay. Thank you.

Operator

Our next question is from Brian White of Jefferies.

Brian White – Jefferies & Co.

Yeah, I’m wondering if you could talk a little bit about the PCB fab market, maybe some of the pricing trends you’re seeing? Utilization rates, [inaudible] flex in the industry and maybe material pricing trends?

Mike McNamara

Yep, so what I’ve got are – the material pricing trends are in a substantial increase so all the raw materials associated with printer circuit boards are going up. In some cases we’re having good success passing those onto customers because we’re trying to maintain that same ratio and I would say we’re having reasonable success at doing that. So that’s – and we don’t anticipate an about-face in that characteristic either. In terms of, and one of the biggest impacts there is, is the copper that’s used in the printer circuit boards.

The utilization rates for us – we’re running very, very high utilization rates. In fact, that’s why we’re adding all the capacity right now, because we’re actually capacity constrained and have the ability to produce, and basically capacity constrained in all our factories so some of our factories have a tendency to produce more of the mobile phone-type products and others are more focused on the high-end, complex printer circuit boards and both those classes of factories are at full utilization and we’re adding capacity in both.

So we see that there’s a great market right now. You know, we think that the copper, the raw materials pricing, negatives is being offset by some increases in prices but what’s not coming off of prices we’re growing our business pretty substantial year on year and that’s offsetting a lot more in terms of overhead savings and such so we’re pretty positive on the industry and doing well to keep our factories full.

Brian White – Jefferies & Co.

And Mike, when we look at the flexible plant that opens in the September quarter, how big is that in terms of square feet? What type of revenue do you think it can support, and what’s the real market that’s going to be using that facility? That’s going to be handsets, or what do you think?

Mike McNamara

Yeah, well first let me answer the capacity question. It’s hard to say. There’s really facility capacity and there’s equipment capacity, and we’re only trying to bring on the equipment capacity as the business comes on so, but let’s say we can do, you know, close to $50 or $60 million per year in that factory at what’s hopefully, you know, margins that are running close to 20%. So we think that’s pretty positive. You know, we – and, what was the other part of your question? I’m sorry.

Brian White – Jefferies & Co.

What market will it focus on ?

Mike McNamara

Yeah, yeah, yeah. So it’ll help mobile phones a lot. There’s – you know, probably mobile phones more than anything else. Our exposure to mobile phones is very, very high. We have the ability to put them into our camera module business and actually vertically integrate our camera module business. We, you know, the mobile phones is a great one. It’s right next to our factory that does the actual rigid, flex, or the rigid boards and so those will probably be the dominant players.

Brian White – Jefferies & Co.

Okay, thank you.

Mike McNamara

Yep.

Operator

Our next question is from Matt Sharon of Thomas Weisel Partners.

Matt Sharon – Thomas Weisel Partners

Yes, thanks. Mike, I have a bigger picture question for you. Given the return to very strong revenue growth, are you concerned at all about potential growing pains and execution risk? We’ve seen that at some of your competitors recently. So have you put any mechanisms in place to manage that growth?

Mike McNamara

Yes. So we’re very wary of that. You know, one of the things I can say about ourselves is that we already run an extraordinarily complex company. We already have a massive percentage of our business in low cost regions and we just run a complex business. When you think about taking into consideration all the verticals, all the design businesses we have, the continuous investment that we have around those pieces, we’re already pretty complex so our ability – the challenge associated with becoming a much more complex company, we’ve kind of already done. So I think the growth that’s coming on, you know a team that has been having to execute in a very, very complex environment and a large environment. So I think that helps us a little bit.

But without question, we worry about it and without question we’re anticipating those growing pains as much as we can and we will have some and it’s going to be a question of how well we, you know, can fix those problems as they occur. But we’re doing the best job we can, worrying about it and anticipating them and, you know, I think we’re pretty comfortable that the ramps that we’re going under right now are actually executing pretty well. So, I’m comfortable with where we stand, our ability to execute, but we do already operate an extremely complex company and I actually think that’s a competitive advantage.

Matt Sharon – Thomas Weisel Partners

Okay, great, and then just back to the issue of margins. You talked about start up costs and other near-term pressure over the next two or three quarters, but could you talk about what the margin profile should look like in the next year or so as those programs ramp and given the change of customer mix here?

Tom Smach

Yeah, Matt, so as I said earlier, I think for the remainder of the fiscal year, as we work through this 25%, 30% growth rate, our objective is to keep the operating margin around 3%. A quarter might be a little less than that; another quarter might be a little bit higher than that. But our objective for the year is to have operating margins be around 3%.

Then as I said next year, the following year, Fiscal 08, depending on the growth rate as start-up costs level out as the growth rate flattens out to 25% of the year or so, and we work through the start-up costs and start penetrating vertical integration at a higher rate, then we think that operating margin will start to increase.

I think for the year you should consider it, you know, around 3%.

Matt Sharon – Thomas Weisel Partners

Okay, but going – looking into FY08, I know it’s a long way off but in the past you’ve talked about 5% or so as a target. Is that still feasible?

Tom Smach

No, no, it’s not. We’ve divested a lot of the higher margin businesses, as you know. That 5% operating margin included the software business, included the network services business, included the semiconductor businesses, all of those are out. So we do have a significant change in the product mix that we have. So as Mike opened his comments, he referred to an analyst meeting at the end of October in New York and at that time we will be introducing some of the new, longer-term financial metrics. But for sure, I think a 5% operating margin needs to go down.

More importantly, our return on invested capital, our ROIC objective, continues to be 15%. So that is slowing increasing over time. We think we’ll continue to increase that and all new business wins that we’re quoting and booking today, we’re looking for an incremental ROIC of above 15%, so I think that’s the most important metric, more so than operating margins, because that normalizes mix changes.

Matt Sharon – Thomas Weisel Partners

Okay, so below 5% but you’re not yet ready to give a specific number?

Tom Smach

No, but we will do that in the October meeting.

Matt Sharon – Thomas Weisel Partners

Okay, thank you.

Tom Smach

Maybe we can take one more question?

Operator

Our final question comes from Yuri Krapivin of Lehman Brothers.

Yuri Krapivin - Lehman Brothers

Good afternoon, everybody. The first question is on restructuring. There are no restructuring charges in the quarter, which is looking great to see and you previously indicated that you are done with wide-scale restructuring however a couple of your peers recently indicated a need for further restructuring in the EMS industry, so I’m just curious whether you are re thinking your restructuring plans for the balance of this year?

Mike McNamara

No. We feel – we’re pretty comfortable with the level of restructuring that we’ve taken. Being a company that has 100,000 people in 30 countries, we’re for sure always going to have adjustments here and there but in terms of a grand-scale restructuring, we don’t think it’s necessary. Our revenue growth rates are going up pretty nicely and what problems we do have, you know, we fully intend to absorb it into operating profits and, you know, occasionally from time to time we’ll have gains in terms of other businesses and we may end up offsetting, you know, some charges against that. But we just – what we see for the future, even if we look at kind of a negative case, we see it as a very manageable amount that we can just absorb and not really have it impact our shareholders.

Thanks very much for all the questions and your attendance today and we’ll look forward to having you attend again next quarter. Thank you.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Flextronics F1Q07 Earnings Conference Call Transcript (FLEX)
This Transcript
All Transcripts