Flextronics: Benefit Coming from Industry Recovery, Outsourcing Efforts

Includes: FLEX, JBL
by: Tom Armistead

Electronics manufacturing service provider Flextronics (NASDAQ:FLEX) is scheduled to report Fiscal 3Q 10 earnings Wednesday. At Friday's closing price of 6.82, and guiding the quarter in a range of 0.14 to 0.16, the company is attractively priced based on historical Price/Sales ratios. The EMS industry may benefit from increased outsourcing as OEMs that have reduced capacity look to outside services as production needs increase.

Overview - From the 10-Q:

We are a leading provider of advanced design and electronics manufacturing services (“EMS”) to original equipment manufacturers (“OEMs”) of a broad range of products in the following markets: infrastructure; mobile communication devices; computing; consumer digital devices; industrial, semiconductor and white goods; automotive, marine and aerospace; and medical devices. We provide a full range of vertically-integrated global supply chain services through which we design, build, ship and service a complete packaged product for our customers. Customers leverage our services to meet their product requirements throughout the entire product life cycle. Our vertically-integrated service offerings include: design services; rigid printed circuit board and flexible circuit fabrication; systems assembly and manufacturing; logistics; after-sales services; and multiple component product offerings.

We are one of the world’s largest EMS providers, with revenues of $5.8 billion and $11.6 billion during the three-month and six-month periods ended October 2, 2009, and $30.9 billion in fiscal year 2009. As of March 31, 2009, our total manufacturing capacity was approximately 27.2 million square feet. We help customers design, build, ship and service electronics products through a network of facilities in 30 countries across four continents.

Acquisitions – The company has grown by acquisition, including a large deal for Solectron in 2007, funded by cash and the issuance of shares. The accumulated goodwill was flushed off the balance sheet during the downturn, and recent acquisitions have been smaller, driven by strategic objectives, to acquire expertise or market share in specific areas.

Presentation – There is a presentation dated 11/17/2009 available on the company's website. I formed a favorable impression based on the information presented. The slides portray an optimistic outlook: specifically FY 2010 – FY 2011 revenue growth expectations, listed by segment, look to be in the double digit range. The projections presented are consistent with my bullish hypothesis on the EMS sector.

Industry Conditions - The EMS sector has not been popular in recent years, although a competitor, Jabil Circuit (NYSE:JBL) has had a wonderful run from the March bottoms. Like most players in the industry, FLEX has reported poor GAAP earnings over the past year. This included a massive non-cash write-down of goodwill in its fiscal 3Q 09. In addition, and like other players, FLEX has aligned capacity with demand, taking the usual charges.

The EMS industry is cyclical and competitive, low margin, and marked by customer concentrations. As such, results will vary substantially even for well-run companies, and volatility becomes the norm. Outsourcing by customers is a primary driver, and somewhat difficult to interpret. Tim Main, CEO of Jabil, generally takes the view that outsourcing increases in difficult times, or in the wake of difficult times, providing growth opportunities. Flextronics, in Management's Discussion (on the 10-K), says that its customers have taken back some work during the downturn.

These statements are compatible: a likely scenario is that customers who retain core manufacturing facilities during downturns will naturally want to keep them busy, while the work that was done in marginal (and since closed) facilities will re-emerge as outsourcing when the economy recovers. EMS players can be expected to do well coming out of the downturn.

Valuation – The EPS numbers here a very bumpy and my usual methods of 5 year average EPS do not work well on these type situations. Under these conditions Price/Sales is workable, and I had good results working with that metric on Jabil Circuits in the same industry.

Taking 5 years of quarterly revenue figures and the same period for daily share prices, I worked out a daily history of Price/TTM Revenue. Over the selected time period, the median P/S was 0.37, while the average was 0.32. The difference is caused by extremely low ratios in the vicinity of the March bottoms. The median is more useful here.

Using projected TTM revenue as of 12/31/09, I get $29.22 sales/share X .37 median price/sales ratio = $11 as a target, within one year. Consensus earnings for FY 2011 stands at 0.69, a P/E of 17 (conservative if growth exceeds 10%) works out to 12. Realization requires continued economic recovery, increased outsourcing, and adequate performance and participation by Flextronics.

Debt/Liquidity – Long term debt as a percent of capitalization at 57.4 is above the 35 that I consider optional. The are no big expirations looming and the company has a 2 billion line of credit, unused. They were in compliance with covenants as of their last report.

Earnings/Guidance - The company is scheduled to report Wednesday. Guidance is 0.14 to 0.16, for what is seasonally the strongest quarter. So far this quarter most companies are beating, running up on the news, and then giving it back. I don't have anything specific, but I am optimistic on the sector, based on economic recovery and the expected increase in outsourcing, and suspect that FLEX will exceed guidance.

Strategy and Tactics – FLEX sports a beta of 2.34 and can be expected to move quite a bit faster than the market in either direction. I took up a starter position ahead of earnings. After they come in, I will update my worksheets, listen to the conference call, and take it from there. Points to listen for will be outlook and guidance, as well as industry trends on outsourcing.

Disclosure: Long FLEX, no position JBL