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Flextronics International Ltd. (NASDAQ:FLEX)

UBS Global Technology and Services Conference Call

November 16, 2011 3:30 PM ET

Executives

Paul Read – Chief Financial Officer

Kevin Kessel – VP, Investor Relations

Analysts

Amitabh Passi – UBS

Amitabh Passi

Okay. Thank you everybody. I think we’ll go ahead and get started. Good afternoon. And welcome to the UBS Technology and Services Conference. My name is Amitabh Passi. I’m the senior analyst covering the technology supply chain companies and wireless handset companies. It’s my pleasure to welcome Flextronics here today.

I will be doing this in a fireside chat format. I’ll ask a few questions and then please raise your hand if you have questions. And presenting the company today is Paul Read, the CFO along with Kevin Kessel, VP of Investor Relations. So thank you, Paul.

Paul Read

Thank you. Thanks for having us.

Amitabh Passi

So, Paul, maybe we are sort of six weeks into the December quarter. I was hoping you could start off maybe by just giving a sense of sort of from a macro perspective, how’s business trending relative to your expectations earlier when you provided guidance? Where are you seeing upside risk, downside risk?

Paul Read

Yeah. Where I would probably characterize it is, this is continuing to be soft demand environment generally across the Board. Every month seems to get a little bit weaker, not drastically, no major corrections, but definitely a slower trend.

There’s pockets of improvements. Seasonally you have consumer products launching or delivering this -- last quarter this quarter, so there is that seasonal benefit. But I think we saw a big correction in the September quarter of the semi cap equipment. That correction has slowed down. It’s still little soft but it’s kind of bottoming out and so that’s probably one of the headwinds here.

But we have another -- number of new programs launching in other parts of the business, in the industrial space, medical, automotive, these kinds of areas. In the traditional datacom, telecom, we guided kind of flat to down in that area and no change there really. So nothing major magnitude of change, still within our guidance range, but just a general softening.

Amitabh Passi

Is there a general softening across all end markets, is it in any particular end market more so than others?

Paul Read

No. Not really. It’s fairly general. The consumer period in September heavy and I think if you strip out the ODM PC business that’s exiting for us take that to one side, in the other categories it’s either stable, in other words flat or softening, just down a little. So we’ve a lot of new bookings and launching new products, et cetera. So, the start of the next year, that’s, as per our guidance it’s kind of flat.

Amitabh Passi

Okay. And then can you remind us where we are with respect to exiting the PC ODM business. I think it supposed to be out by the end of this quarter, maybe you can provide us an update how that’s progressing?

Paul Read

Yeah. So it progress as planned. I think we ship our final products this month. So, yeah, there’s definitely a hard hold and all the activities to do with cleaning up and transferring to the new supplier, et cetera. That’s all on track. And repositioning the assets, there was over 200 machines SMT machines that have be -- will be redeployed within weeks here. We have demand for all of those. And that will certainly help going forward in terms of lowering the CapEx spend for next year.

So pretty pleased with the way we’ve managed the assets through this business and we’ve got a pretty good hard hold this month and a clean start in the New Year.

Amitabh Passi

Okay. Maybe I can just touch on margins briefly. I think you reported 2.2% operating margin in the September quarter. The December quarter guidance, I think implies slight improvement despite an incremental 25 bips of headwind from the PC ODM business?

So the first question was, if you could just remind us how you get that margin improvement in September and then once we, sorry, in December? And then once you move into the March quarter, can we expect an incremental 50 bips with the PC ODM behind it?

Paul Read

Yeah. The December quarter is heavily negatively influenced by the PC ODM exits. We told everybody that we’re spending roughly $50 million in December to exit that business on a one-time basis and that’s still on track.

So when you take away the -- take away those numbers and you look at the mixed profile in March, for example, where there is less consumer exposure, because it’s typically a down quarter in terms of the amount of consumer business, because it’s post to holiday period.

We’re looking at a 3% plus margin profile and that’s what we said was 3% to 3.5% in March, which is clearly a huge turnaround from the December period when we’re looking at low 2% numbers. And so, that correction is really ODM PC, as well as in March, we always get a better mix and about 3% to 3.5% is kind of something that’s we’re targeting for and on track to achieve.

Amitabh Passi

And what’s implied with respect to the components business?

Paul Read

Well, the reason we gave a range of 3% to 3.5% is, we’ve always set components of worth about 30 basis points of improvement when they hit a target, short-term target of 4% margins. And so, if they don’t hit that target, they hit the low end of the, they hit zero percent then they’ll be at the low end of that range, if they hit 4%, they will be at high end of that range. So that’s really what determines the range of achievement in the March quarter for the overall company and that’s how we’re looking at it.

Amitabh Passi

Okay. In terms of normal seasonality perhaps you can remind us and this is always a very confusing aspect of your business, it’s changed quite a bit, particularly after Solectron. As a decline in mid-to-high single digits, it’s still the right way to think about normal? And maybe you can also just announcing that give us a sense, does the Chinese New Year timing have any bearing on that seasonality like what’s your expectations are?

Paul Read

Yeah. I think if you strip out of the December quarter of the ODM PC revenue which is roughly $200 million and then you compare December to March, you’ll -- you do get that mid-to-high single-digit decline for the overall company in revenues and while we don’t have real good visibility of March yet, that’s what we’d expect.

The Chinese New Year, it isn’t having such a big influence on us as yet. I think in years to come it might, but a lot of the demand for the period is generally satisfied early on in the quarter and a lot of the consumer spend in China, domestic spend is fueled by, really we’re not supplying a lot of that type of product into the market domestically.

So if there is, if it becomes truly a season in itself like our holiday seasons elsewhere in the world at other times than it could to be a factor in the future, driving demand up in the March quarter, if we were servicing products. But we’re not servicing products and it’s not really a significant demand uptick. I don’t think at this stage but in years to come it probably could be.

Amitabh Passi

Okay. If anybody has any questions, please feel to -- feel free to raise your hand. Paul, just quickly on the components business, if I can just go back there, assuming if you were to come in at the low end of the March quarter, let say zero percent? Is it basically a quarter lag before you get to that 4%, how should we think about the progression and through the year, if you were to be at the low end?

Paul Read

Yeah. That’s how we would think about it. We’re really working hard to achieve that and we’ve said that all along. What we’re concerned about and what everybody else worries about is the macro demand and any down draft that we get because that’s going to affect the consumer business, the product, the components business as well.

Particularly, like some multi-printing circuit board business, it’s very diverse service in many industries and is one of the leaders in terms of the components profitability improvement of the overall group. So if there is some corrections there in demand and that could hurt the revenue pattern, which could hurt the profit pattern of that group. That’s not what we’re planning on. But with all news out there and some of the early signs, it’s certainly something that could be a headwind for us.

Amitabh Passi

Any questions out there. Okay. I’ll keep going. I think over the last couple of quarters you’ve build up a steady pretty strong pipeline of orders in your industrial and emerging segment, good pipeline in medical, I think the numbers are somewhat like $300 million in the last quarter for I&E and then maybe $500 million pipeline total for medical. How do we think about when these orders actually turn to revenues, what’s the lag?

Paul Read

Yeah. That sector for us has been very strong year-over-year. Last year, I think we booked $1.3 billion of new wins. This year so far we have booked approximately $1 billion in new wins. So it is very strong. It’s $4.5 billion business for us. We are growing our business 15%, 20% plus, so it’s pretty strong.

Now this year it’s had bit of a downdraft with a semi cap equipment space because there is a quite a bit of revenue in there for that. So I think the growth rate for this year has slowed, but the bookings for next year are very strong and that’s where we would expect that 15% to 20% to come back.

Typically, our six to 12 months kind of sales cycles from booking to delivering and it’s a very diverse product, 85% of our customers have revenues of less than $15 million a year for us. So it’s very wide spread both geographically around in 30 plus facilities around the world in local regions rather than the campuses -- big industrial campuses that we have. These are more in regional facilities close to the customers around the world.

So and then the customer base is very diverse as well. We have many different sectors of this, whether the kiosks capital equipment, clean tech, home appliance and many others as well. So it’s a lot of new wins, there’s lot of new outsourcing for us and there’s a lot of market share gains as well and its good rates and good profitability from that business.

Amitabh Passi

A large European telecom equipment vendor recently spoke about wanting to outsource some more business by the end of this year. I was wondering if you could give us maybe just roughly any sense of what that statement means, are they speaking of divestures, is it more about just moving existing business from facilities in-house to contract manufacturers and would that be a potential interest to you?

Paul Read

Yeah. We work with all those customers very closely. Our business has grown very well. We have very dominant position in the traditional datacom, telecom networking space. It’s a biggest part of our business and we were always very engaged with customers when they want to make strategic moves like this.

I’m very encouraged by this same time. So I think that it means more outsourcing and that’s something that we provide excellent services for the customer. I think that you mentioned is growing with us very fast, and so we’d hope to participate in someway with that. And I think over the last few years we’ve participated and grown our business very well with that customer and I think we have an outlook to grow it considerably in the future.

Amitabh Passi

Any questions out there?

Paul Read

You’re asking all the good questions, Amit, today, you’ve taken it out from.

Unidentified Analyst

Can you just touch briefly on demand trends in your integrated network solutions, what do you seeing by major set of sub-segments in that segment?

Paul Read

Yeah. We guided flat to down this quarter, the segment had grown three straight quarters very well sequentially and so, having one quarter when its kind of flat to down is okay. But for the year, we would have grown double digits fiscal ‘12. So we’ve always said, we grow this business 8% to 12% year-over-year and this year we should be right in the sweet spot of that.

So it’s great business for us. We have great relationships. And I think that, if we look at one particular aspect for 4G, LTE kind of space, wireless, we have a very strong dominant position in that space. So great capability and I think that’s why customers continue to support our business with their business and its working out to be really well. So that’s very strong for us.

There has been a lot of product refresh this year with certain customers of ours and we’re really pleased that we’re on most of the new programs that are coming out and now add we had some delay early part of the year, and now we’re shipping those products and so that’s proven to be really well.

It is very much dependant, you know in the space because it’s a big category is, are you on the right products, are you with the right customers. And sometimes you get out of position and sometimes you are right in the sweet spot. So we are just happy that we’re doing a great job for these customers and we run all the right products. So that’s why we are pretty confident about our growth in this segment.

Amitabh Passi

Well, okay, right there.

Unidentified Analyst

Can you just talk about where you stand as far as capital allocation, balance sheet much stronger now than it was, bottoming away, you aggressively brought back shares, you continue to buyback shares. Just how do you think about what the right balance sheet leverage is? How far you may go over the shares there around the current price manage continued down? But just how you and Board are thinking about capital allocation going forward? Thanks.

Paul Read

Yeah. I think our balance sheet is in great shape. Our liquidity is excellent. Our free cash flow is excellent. We’re very comfortable with the leverage level that we’re at and have been fixed to that level for sometime, recently concluded a $2 billion facility, which is $500 million term loan on a $1.5 billion revolver at the end of last quarter. So, that, we don’t have any more maturities until 2014 now. So I think the, it’s very stable and with debt-to-EBITDA at $1.9 trending down, we’re very happy with that.

The way we view the capital allocation is no different to what we’ve done before is we would like to have the free cash flow to spend. We think that we’ve added good cash balances, adequate liquidity to run the company and probably have excess cash actually at those levels. Nevertheless, we’d like to make sure we generate the free cash flow and then spend it appropriately.

We have probably spends roughly our depreciation when it comes to CapEx. So we’ve been able to keep the engine going at that level. And then, really it’s down to opportunities whether they are growing the business, M&A or share repurchase. You’ve seen us to do very little M&A this year and we have few things planned, but nothing major. But, so then we’ve turned to use it for share repurchase, as you’ve seen we’ve taken out probably 14% over the last, since we started the program actively about 18 months ago.

We’ve been active at $6, $5, $7, we truly believe that where our multiple is today is not where it should stay and as we work through this turnaround of the portfolio exiting some of the high velocity businesses that the margin will increase and hopefully what will follow is an improvement in the multiple, as well as an improvement in the earnings.

So that’s why we have been active to-date. And we take those decisions every quarter. We are looking at free cash flow that’s coming in, opportunities for that cash flow and you’ve seen us turn to share repurchase since it’s proven to be very accretive for us.

Unidentified Analyst

Hi. Can you comment on how much slack capacity you think your competitors have and in particular I’m thinking about Celestica, they lose some business from Research in Motion?

Paul Read

What was the question, how much?

Unidentified Analyst

How much slack capacity your competitors have, if they are going to start lowering prices to sold their plants?

Paul Read

Excess capacity?

Unidentified Analyst

Yeah.

Paul Read

Okay. It’s difficult to comment on how much they have. I think that there’s been very rational behavior in pricing with the North American competitors since the downturn, so few years now, everybody is really respected that side of it, as well as the customers have.

There are pockets of constraint, I’m sure, but and then pockets of access, not all capacity is equal. But I think that, it will continue to be competitive. This industry has been through these cycles a few times and I think it’s learnt that, it doesn’t do anybody any good to go fight over capacity utilization and therefore pricing. Well, it might have a short-term effect, long-term it’s pretty damaging for the industry and we haven’t seen that late. And I think everybody is doing a good job of diversifying their business into other sectors of new outsourcing to fulfill the capacity that they have.

So, I think, it’s fairly healthy. It certainly reflects strong, I’m not sure about the other guys. But you just got to make sure you’ve got a good pipeline of other business. If some things fall off, you can fill them up with, just like we did in the facility in China with ODM PC, take those 200 machines and run them across the company and they all plugged in a month later. It’s just the right way to do it and you have to flex the capacity of the labor force very quickly. We run a high percentage of temporary labor and contract labor, so that we can react very quickly up or down.

And land and buildings, the lowest cost of capacity, so you don’t tend to worry too much about that. But, the way we think about the next few years is, we have enough land and buildings in place to satisfy the demand that we think is coming our way.

Amitabh Passi

I think we have a question back there.

Unidentified Analyst

Yeah. The operating margin performance for you guys, if you look back past four to six quarters, hasn’t really met what your expectations were or what you have told people that you can achieve. And now, again, you are putting expectations of operating margin improvement over the next two, three quarters that look pretty aggressive, but you’re taking certain actions that should enable you to get to some operating margin expansion. What are the risks to this improvement that you guys are talking about right now and how are you accounting for them, so that we don’t get another surprise?

Paul Read

Yeah. We don’t get surprises as well. You have to look at, we’ve made a major shift in this portfolio ending this month. You take out, in the September quarter we had a $700 million revenue run rate for this ODM PC business. So it’s nearly $3 billion, that’s 10% of the company has changed, gone away that was losing considerable amount of money. So, with that out and with the January 1 cleans stock that’s where we feel confident that we can make the step change in operating margins.

What could put that at risk? Just becomes like any other part of the business. Its any real macro corrections, headwinds that are right there or we haven’t seen yet that might be coming in a very short period of time, that’s certainly can happen, I mean, that can happens to everybody though. We will - we won’t be on our own there.

Apart from that it’s all about execution and once we and essentially not only remove a low margin or negative margin piece of business, we’ve taken ourselves out of the volatile piece of the industry. That has changed over the last few years from something that was less volatile to something that’s very volatile.

And our approach with our portfolio management is to derisk this portfolio that we have. So we can have a more predictable earnings pattern and execution and that this certain pieces of business that we look at everyday that make that very difficult. And so that’s one – the main reason why we exited that business.

Amitabh Passi

Paul, just quickly on M&A, which areas have most interest to you? And then, I’m also curious from a structural perspective, do you see any benefits from the larger scale consolidation, if the number four or number five players got together, the five with the six from your perspective, is that an interesting development, would you be indifferent, would it help the industry or not?

Paul Read

Yeah. I think we were disappointed after we did the big move with Solectron that it didn’t set off a wave of repetition, that some of the others didn’t do the same thing. I think consolidation is good for the industry and brings about not just more pricing discipline, but capacity and capability to service the customers. Its one of the reasons we did.

And the main reason we did the acquisition with Solectron was to bring more capabilities and capacity to our company because when we match the two up, we were heavily concentrated on more of the consumer space and they were in mostly in the non-consumer space. So when you put the two companies together, you had a far more enriched service offering for your customers.

And I think that whenever you -- if you do it right and we execute it really well. What if other companies would do that? I think there are very strong companies to have very good service offerings. So less people then certainly helps the industry but we have no desire to do that and disappointed others didn’t, but that’s their own choice.

So I think that’s and then on the general topic we have M&A for Flex. We’ve built this $30 billion company with 200,000 people and tremendous capability around the world over a period of 10, 15 years. We are – we like what we’ve got. There is certain pieces of portfolio that will always proven and managed differently, but we have a tremendous offering for our customers in all areas.

We are deemphasizing the consumer space or the high velocity space and you see that with the exit of the ODM PC business and we’re doubling down our resources whether the cash in terms of supporting working capital for organic growth, M&A opportunities to support the growth of certain capabilities we don’t have today or just management resources and talent and time that we are putting into these growing industries of medical, aerospace defense, industrial businesses, automotive businesses that are growing for us 15%, 20% and have really good margin profiles, and a very diverse business units and very, therefore, less volatile business units with more predictable earnings span. So we like that space and that’s where we are investing.

When we talk about M&A, we are not talking about large scale M&A. These are more tuck-in acquisitions or capabilities, so that we can get a jumpstart on servicing the customer a new part of the business.

We are very good at growing organically or synergizing into the customers that we have with other offerings by developing greenfield solutions and buying capital equipment to actually service it. We don’t have to do an M&A for that. But there are certain opportunities out there that we look at.

Amitabh Passi

I think, with that, we are out of time. Thank you so much, Paul.

Paul Read

Thanks very much everybody.

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