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Flextronics International Ltd. (NASDAQ:FLEX)

Goldman Sachs Technology and Internet Conference

Feb 15, 2012 01:20 PM ET

Executives

Paul Read - CFO

Analyst

Craig Hettenbach - Goldman Sachs

Craig Hettenbach - Goldman Sachs

Great. Good morning, everyone. I'm Craig Hettenbach. I cover the IT supply chain at Goldman. Very pleased to have with us today, Paul Read, CFO of Flextronics, the second largest EMS company. So, thanks for being here, Paul.

Paul Read

How are you, Craig. Good morning, everybody.

Craig Hettenbach - Goldman Sachs

Great. So starting to kick off just being the second largest EMS company, such a lot of different end markets and just to get your sense of demand trends, inventory, what you're seeing out there, what you're hearing from customers at the start of the year?

Paul Read

Well, not much change to what we had talked about on our call at the end of January. We think the demand is pretty stable. Last year, we did see towards the back end of the year, multiple periods of a down graph, but that's stabilized in the December, January, February timeframe. So, we're very pleased with that. We're in a period right now, March quarter of course, it's a down graph in terms of consumer demand and some of the consumer products. But, the other businesses that we have NC and a stable to growing demand in the other sectors for us. So, that's pretty encouraging.

To break it down a little bit, our INS business actually is seeing some nice growth and did go through a period of December quarter inventory correction essentially with a number of customers, and I think we've come out of that now and we're starting to see some growth here in the March quarter and beyond.

We also had some good new wins in the December quarter. I think we booked about $1 billion of new business in the December quarter and a significant win as part of that with one of our top customers. So, I think we are on all the right programs in that business. And we have great capabilities and so we really are doing very well in that business, and we're very encouraged by that.

The industrial and emerging industries business for us is very exciting. It's growing very fast. It's on pace to keep growing 15% plus. And a large part that growth is coming from some of the clean tech or smart grid area, kiosks, appliances and other sectors like that that we've seen growth in in the emerging markets, and that's something that we've seen over this past fiscal year and the next fiscal year.

We booked approximately $1 billion of new business in the nine months of this first fiscal year, and we're on track to book, probably about $1.3 billion to $1.4 billion of business now for this full fiscal year that ends in March, which is what we did a year ago as well in fiscal 2011. So in fiscal '13 should really hold up for a 15% plus growth year for that business.

The High Reliability business, that's growing very fast as well. That's principally medical, automotive, aerospace and defense. And we booked approximately $300 million of new business in the first nine months, and that business should grow next year approximately 15% plus, so very encouraged by that as well. There is some exciting areas in that for us, particularly in automotive and aerospace and defense that we're penetrating and doing very well.

The other part of the business, the high velocity business, which is essentially the mobile and computing and printing, consumer device kind of area. That's, obviously, in a seasonally down quarter in March quarter, and we said that would be down some 30% to 40%.That seems to be holding. And as you know, have exited the ODM PC business in the December quarter. So, the revenue for that obviously was approximately $1.5 billion fiscal '12, we're obviously not flow through to fiscal 2013. So we'll see some down graph in fiscal '13 of those numbers.

It's a business that we're still obviously investing in, but we're actually seeing somewhat of a reduction in our business in that area, principally through the ODM PC business going away and some of the other mobile, smartphone business that we will deemphasize this year.

So, I think fiscal '13 over '12, the next year, will be a very difficult year in terms of revenue, of course, for that business. But the growth in all the other businesses is very strong and utilizing all the capacity that's left behind by the reduction in the high velocity business. And so, I think it'll balance out very nicely to, for us, what is intended to be 70%-30% mix of low-margin, high-margin business for us.

Craig Hettenbach - Goldman Sachs

Got it. Appreciate the overview by segment there. The comment on the mobile side in terms of deemphasizing against it, is that just the volatility of that business, the margin that longer term you're looking to invest in different areas more than that?

Paul Read

Yes, we like the move to a 70%-30% split of the low-margin, high-margin businesses. As a model then for the company, we'll certainly see improved margins in the 3.5%-plus range, but we'll see also less volatility in our business model, less risk, less variability and we really like that.

And 30% is still a significant part, but this year I think we ended up with a 60%-40% kind of split, next year it'll be more like a 70%-30% split. And at that level, I think, everything works together really nicely and provides attractive growth opportunities for us as a company and good margin profiles and very, very strong free cash flow.

Craig Hettenbach - Goldman Sachs

Just to touch on outsourcing trends in EMS, on the one hand the traditional business there is macro influences, just how customers think through, how they want to outsource and the level. And then also you have more kind of emerging or underpenetrated markets like industrial and medical. So any high-level trends that you could point out that you see driving growth?

Paul Read

Yes, those two areas for us, the high reliability and the industrial and emerging industries piece, we're very excited about that area. We over the last couple of years really focused on increasing the capabilities that we have in that space because that is where most of the new outsourcing is coming from. It is very strong, and we've been very happy with the wins, like I just talked about, in those areas.

For us, in the high reliability sector, medical is growing fast for us. It's now over $1 billion of revenue and growing 15% plus a year for us. So it's actually a very attractive business. It's very different from normal business, of course. We have very specialized type equipment, we have dedicated factories, FDA approved factories, very strict, stringent quality systems, and we have that capability in scale both in Mexico, in China and now in Europe. So, we don't have a fragmented approach to that business. We have a very concentrated campus approach to 4,000 or 5,000 people centered in one location in Mexico, in China and now in Eastern Europe.

So, I think we have the right offering to these customers, and we seem to be, through the bookings at least anyway, very successful in booking new business in that area. We're investing in that area, particularly in precision consumable plastics area and that's where we will place many investments. We're always looking at tucking M&A opportunities for that business, and we've been doing that, they are pretty small, but they actually add a lot of capability and a lot of new customers for us that's pretty exciting. So, that's been very good.

So medical is an area that we've concentrated on last couple of years, it has been very successful, it's grown very fast and I think it continued to grow very fast for us and obviously a very attractive margin profile and it's a very sticky business. The sales cycle to book this business is very long but once you do it, it kind of hangs around for a pretty long time as well which is very good business to have and great customers that we have as well for that portfolio.

The automotive business for us has been very successful. We grew 40% last year. It’s concentrated mainly in the connectivity space for us with some North American customers that supply these kinds of products into the automobiles around the world, so not just in North America, but in Europe and APAC, and actually we're seeing tremendous growth there and we're very pleased with that.

We also have interior lighting, exterior lighting kind of products as well that are doing pretty well. And we've recently hired a new President to run that business for us, and we see a lot of opportunities there to increase the size of that business. And again, great margins, great stickiness, and great customers, so that's been very good.

And in the industrial and emerging business, emerging industries that we have, we've great footprint. These are the kinds of products that you have to be in most corners of the world to supply to the local marketplace. They've usually low-volume, high-mix products, high margins again and great customers, great stickiness.

For us clean tech has been a big year for us, this year in particular, smart grid, gas meters and electricity meters that converted over to smart meters. We have all the top customers in that customer stat that we need to enjoy that growth and that's what we're doing. We've just hired a President who is well respected in the industry to come in and run that sector and take it to the next level for us, because it really has become a big business for us. It's not just solar panels and modules and inverters and these kinds of things, it's a lot more beyond that. So, we really have doubled down the gas in the effort and resourcing need to accelerate the growth of that business for us.

But outside of that capital equipment, which really had a tough end six months to last year selling the year, has started to turn around and we're starting to see the growth again now for the first six months of this year and beyond hopefully. Again, it's really a good business. We offer a great deal of services in that highly complex assembly, integration, machining, plastics, metals, all these kinds of the products that we put into this. So, it's a great business. When it comes back and we'll enjoy that, of course. But it did have a tough last six months, but it is starting to turn around.

In addition, kiosks is continuing to grow for us. Appliances in the emerging markets is growing very strong for us. So these areas are the highlight of the industrial engineering. We're very confident of these 15% plus growth year-over-year kind of numbers because of the strong bookings and the customer base and the service offerings that we have, and I think that it should bode well for compensating for some of the high velocity business that's kind of down-graphed this year year-over-year.

Craig Hettenbach - Goldman Sachs

Okay. There seems to be a greater focus across the industry on these types of markets. So, can you talk about just the competitive landscape and how it contrasts with some of the traditional higher-volume markets?

Paul Read

Yes, it's certainly more regionally focused. So this isn't a build cheap in China model. These are low-volume, high-mix products, high complexity and while it's competitively priced, certainly isn't in the same zone as some of the, obviously, the consumer products that have matured in outsourcing markets for many, many years.

So, it also has a different capital profile in that you need more capital to run this business, whether it's in the equipment or in working capital. So, you have to have a higher operating margin to make sure that return on capital actually comes out to where it needs to be. And customers understand that, so I don't think there's an issue that we foresee in the short term at least with margin pressure in that area.

There's certainly a lot of business to go around and because these are truly worldwide markets, and we're starting to see more and more outsourcing from some of the smaller customers that has been there perhaps manufacturing for themselves for many, many years and come through the downturn and really looking to outsourcing to grow their business or protect their business going forward. And we are there, obviously, the provider of the solution for them, not just on a regional basis but on a worldwide basis should their products go into higher volume in the future, and that's the attractiveness they like. They come to Flextronics because we offer them kind of a boutique service on the low-volume, high-mix business. We have a very focused strategic marketing approach to the business that is treating all these small customers very, very importantly, just as important as some of our larger customers. And then, if they do grow the higher volumes then, of course, they can enjoy the footprint that Flextronics offers in the competitiveness that we enable them with when they get into such volumes. So, it's working very well. And I do think there is a lot of opportunity out there to do even more. It is about investing in some of these areas, some technologies, capabilities whether that's in the equipment or whether that's in the people and resources you need to run these businesses. We've recognized that. It is different and we've doubled down on the resources and applied the capital so that we can certainly sustain the 15% to 20% growth rates going forward.

Craig Hettenbach - Goldman Sachs

Have to switch gears a bit and just touch on social responsibility, bond release from capital, that's been in focus here. Flextronics has a very large presence in China. So just touch on how you view that and really give investors a feel of how you run the business from that angle?

Paul Read

We're actually very pleased with the attention it's getting. With 200,000 people around the world and 80,000 to 90,000 people in China, and we approach China like we approach every other region of the world. It is no different for us. Our social responsibility, we take very seriously. We've invested highly throughout the years in this area, providing a very positive work environment for employees so that they can sustain long-term careers at Flextronics, and we've seen many, many people grow with Flextronics in China, or in Brazil, or in Eastern Europe through enjoying the work experience that they get with Flextronics.

We have sat back and seen competitors have a different approach, particularly in China, and I just hope that this focus and attention that's being brought through the media it will help level the playing field in some way for Flextronics going forward and for the rest of our competitors that actually do a very good job in this area.

So, I think its being born out in the number of awards that we've had from independent third parties over the years and more recently as well we're one of those highly-regarded in respected companies to go work for in China, and we hope to continue to have that mantel of the employer of choice. So, we're actually pleased with the attention, because it just highlight one of our strengths and highlights for us any way the return on investment almost that we've been putting in over the many, many years of taking this very seriously.

Craig Hettenbach - Goldman Sachs

Okay. Just extending that to the manufacturing footprint, big presence in China, can you just give us an update on over a longer-term basis, geographies that look appealing to you to expand?

Paul Read

Yes. I've been around long enough with Flextronics anyway, 17 years, to know that before the boom there in China, places like Malaysia, Indonesia were very strong in terms of offering great supply chain solutions and very cost competitiveness. And it's interesting to see how that's come back full circle and there are parts in Malaysia now that are equivalent in terms of labor cost as part of China.

And so, we do see customers looking for or at least inquiring for alternative approaches and Malaysia and Indonesia are good examples of that. It's still to be said though that China has a very strong supply chain and that can outweigh sometimes the labor cost differential. So, you'll still see a vast majority of products being produced there. But it is making customers, and has been over the past three or four years, customers inquire about the total supply chain cost solutions coming out of other regions, and we see that in Southeast Asia, we see it back in Latin America and Eastern Europe.

We have great offerings to these customers out of places like the Ukraine, for example, which offers a very cost competitive solution into most of Europe and Russia included in that. So we have a very strong presence, great relationships and customers already in these regions, and we are very well positioned for any new business that comes our way. We have the capacity and we have the management structure and systems in place to take advantage of these opportunities.

Craig Hettenbach - Goldman Sachs

Okay. It sounds like here in the US or headlines on manufacturing. Are you hearing anything from your customers in terms of how they evaluate, particularly as it relates to indulgence in US?

Paul Read

Not too much. It's divided up a little bit in that in the high-volume consumer business, not really at all, that's still bound for the East. But in our industrial and emerging Industries and high reliability to the medical, automotive and industrial kind of products, yes, for sure, they're less cost sensitive and really focused on the solution, the technology and being close to the market. So I don't think that's changed at all. That's how that's always been. But we really haven't seen a big push for bringing onshore some of the work that went offshore previously. It's still a big delta in terms of cost for these customers to absorb that in mostly the consumer products.

Craig Hettenbach - Goldman Sachs

Okay. We talk mostly about the traditional EMS business. Can you talk about the components business? I know you have tropicals there that you're looking to expand the margin, just where the difficulty has been and really just the strategic rationale this business that you see to make work.

Paul Read

Yes, the components business has certainly, as we know; it's underperformed in different ways. I think that we have a real good grasp on the opportunities and also the challenges within that business group. Multek is a big part of that and that business actually come through the downturn where it did underperform significantly to a point now where it's actually starting to make some money and starting to grow. And we put investments into that business, into certain technologies that customers are looking for, whether they're producing smart phones or tablets, they need some higher-layer content boards and there are not many printed circuit board suppliers out there that are investing in this type of technology. But we decided to do that a couple years ago and it's starting to come through with new business wins that we're seeing for next year. So I think most of that is fine. There is obviously pieces of it that we actually have to work through, but for the whole, we're pretty comfortable with that business.

The challenges of being on the power supplies and the camera modules business, we've taken a real hard look at that business in this last quarter and those businesses in the last quarter, looking at strategic alternative, looking at cost reductions, and right sizing some of the businesses that we have there.

So, we took aggressive actions on the power side, to reduce the footprint and that will take another six months, but we're very, very excited about when that is done, we'll be down to a very simple two-factory footprint, one in inland China and one on the coast side that will service that market very well. They do a lot of adaptive, challenging kind of business. Large smart phone customers are actually giving them

Increased orders in that business. And so, I think with the footprint, the new business awards in power actually would be a very, very strong and profitable business for us by the end of the year.

The camera modules business, that principally supplying some smartphone technologies and the products are doing really well. I think we've been caught in the last six months between product cycles and the revenues have gone down in the December and March quarter here, but they put a lot of new business with the leading providers there, and we're ramping that. We're very busy right now, and we think that that will come through for us for the back end of the year as well.

So I think that we've had our challenges. Last year was a tough year, disappointing. But I think that the second half of this year should be very encouraging for us. And hitting our profit goals of 4% as a bundle (inaudible) should be attainable. But we try to structure the business such that to hit this 3.5% margin goal, should be able to do that without the need for components to make money essentially, and to almost take that off the table as an unnecessary element to get to that.

And if you look at kind of $7 billion of revenue a quarter with a 70%-30% split of low margin, high margin business, you can get a 3.5% margin out of the business without components actually contributing. So, should they contribute the back end of the year, we'll be in that range of the 3.5% to 4%, which we've always said is our operating margin target. And I think, we can get there and do that the second half of this year.

Craig Hettenbach - Goldman Sachs

Just going back to that footprint, the two factories, just how is that compared to 12 to 18 months ago?

Paul Read

It includes about five factories in power. We acquired a power business and it came with a number of legacy customers, products and facilities, and I think we were slow to rationalize that. We spent the time really trying to fix it rather than rationalize it, i.e., shut it down in some way.

And so, we have two assets ongoing right now. One is, cutting down the number of facilities; we shut down a couple last year. We're going to be shutting down another one this year, early part of this year. And then the other part is the customer base and the kinds of products that we're producing. And we'd rather be in the volume manufacturing in the power supplies than in the low-volume, high-mix kind of customers or products that are not yielding return that we need to have. And so we're rationalizing both sets of footprints and customer and customer product base. And we're in the middle of that right now and that will be done by the middle of this year, and I think we're in great shape there.

Craig Hettenbach - Goldman Sachs

Okay. And just looking to capital allocation, Company has been very aggressive in buying back stock. So, I just wanted to see what the strategy is going forward and then also would a dividend fit into that strategy on a longer-term basis?

Paul Read

Yes. I think our free cash flow has been the strength, the underpinning strength of the company for many, many years and this year, we'll have $400 million to $500 million of free cash flow on the back of what's been, for us anyway, a disappointing performance in terms of operating margin. So, if we can produce that kind of free cash flow with that scenario, when we look to the fiscal '13 now that starts in about six weeks, April 1st, we have very high hopes for free cash flow beyond that $400 million $500 million that we'll turn in this year.

And so with substantial free cash flow and essentially our footprint build-out as a company and managing a portfolio to just to optimize the mix to improve margins and therefore improve free cash flow, then it's about how do we deploy that. And you've seen us last year deploy a significant amount; some 15% of the flow was taken out in the shares because we generated substantial free cash flow.

But really our focus every day is about growing the business. Working capital, capital expenditure, some small M&A kind of tuck-in acquisitions are what's important to us and that's what we will do. You saw us in the December quarter spend roughly $80 million on some working capital for a new divestiture for us from one of our leading infrastructure customers to take over a large piece of business. And so, when you have that kind of free cash flow, you can afford to do those deals and actually support the customers in that way.

Beyond that though, we understand with the stock price where it's at and largely because of our performance this year, fiscal '12, it's been a great opportunity to buy the stock at a relatively cheap price, given the low multiple it's yielding today and that's been very attractive at those prices it's also been very accretive. On average, purchase price of the stock has been around $6, and sold around $7 now.

So, I think we've used the cash well out of the free cash flow. I think it's yielded a good return for the shareholders during a very difficult time for us. But going forward, it's not our intent to be a serial share repurchaser. We hope to fix the performance of the business, the operating margins which should in turn, I hope and also provide some level of stability into the business by having a 70%-30% split with less high velocity therefore less volatility in the business. And with that, I think, you'll probably hopefully see the stock price rise and we get more than the average P/E of the peer group. Then, I think, we'll be switching gears to think about other things, like dividends, for example, to offer out to shareholders because it makes no sense to keep building the cash balance when there are other opportunities to reward shareholders and that's really the way you think about it.

Craig Hettenbach - Goldman Sachs

Okay. A few more minutes here, but I'd like to open it up to the investors. If there are any questions, you can raise your hand.

Question-and-Answer Session

Unidentified Analyst

So just following up on the target, trying to get high velocity down to 30% from around 40% today, could you just talk a little bit more about your line of sight? I know you've already said a fair amount about that. But I guess the crux of my question is just how confident are you and in what timeframe do you expect that to occur, and how confident are you that you can obtain that, and could you get it even lower than 30%?

Paul Read

For sure. This high velocity business has a very short product life cycle. And so, the products come up for rebid every six to nine, 12 months, and if you don't want to participate in those programs, you simply don't bid on those programs. And it's unlike getting into some of the other products that have a two-year life cycle. So, it's not difficult to de-emphasize or reduce the volume in that business. We have some really good customers in that portfolio, and we're in a favorite return, good return on capital. They generate cash for us, they absorb capacity and they're just great customers and products to be with and we'll always be with those customers.

We worry about some of the customers and their exposure to their end markets and whether they're actually going to succeed or some of the volumes are going to fall off. So some of that is our anticipation of how some of those products in the market will fit, and therefore how the demand then comes back to the outsourcing providers, and some of it is our deliberate attempt to reduce our exposure to some of these customers such that again back to the whole volatility and risk element of our business.

So we're lucky in that our largest provider in that area was HP and it was roughly on 10% plus, but we've exited the ODM PC business and now that drops down significantly. So we de-risked that to a large extent. But we have another large customer in that business, as you know RIM, in mobility sector, and they are up around 10%. So that could happen as well, but we're not like some that have perhaps more than that, maybe 20%. So we're not really putting ourselves in that category of risk. But certainly reducing our exposure there would go a long to the 30%.

We actually have a 30% this quarter, so it's about a 30%-70% in the March quarter, but the revenue is of course a significant less. They're down around $6.5 billion or so. So you won't see that margin profile this quarter because you really need about $7 billion a quarter, which should be ahead of us now as we climb out of the March quarter here to the back end of the year.

Unidentified Analyst

A fight forming on stock buyback, did you say you bought back 15% of the stock but thought you are limited to 10% a year?

Paul Read

Over the last 18 months, 15%. We're limited to 10% until December, from the AGM July to the AGM this year July, we had purchased roughly 5% of the 10% allotment that the shareholders have given us. So we have another 5% and the board also approved the whole 10%. So we still have roughly 5% to purchase.

Unidentified Analyst

All right. Could you share with us how the company came up with a 3.5% margin growth? Is it from benchmarking peers or derived from certain within target? And also is there a more granular margin target for the high-margin versus low-margin business of yours?

Paul Read

Yes, we have some businesses that have double digit margins and we have obviously high velocity business that's more around 2% margin. So, it's very diverse across the products that we have. You get 3.5% by just doing $7 billion at 70%-30% split and that's kind of the number you get.

Our long-term goals have always been, we've stated this for many, many years, of 3.5% to 4% margin. We think that at our size of company, $30 billion plus, is actually when you model that through, very attractive from an earnings growth, margin and free cash flow perspective.

The way we run our business though is a return on capital. So, we expect a 20% plus return on capital from all of our projects, whether they're low margin or high margin. It's a return on capital business. So, we focus intensely on asset velocity where there is low-margin business of course. But we've seen this in the December quarter as we report 2% business. But when we exclude the ODM PC business, it is actually 3%. Getting to 3.5% is something that we have in our sight, and then any improvement beyond that will come from other ways of this business growing components, like I talked about earlier, and aspects like that. But I think we're very comfortable in that 3.5% to 4% range.

Unidentified Analyst

(Question inaudible)

Paul Read

Oh, yes, for sure, I mean, this is something we've said before. The high velocity part generally earns around 2% margin business, some of its 3%, but the high reliability, industrial engineering, they're all 5%, 6% margin businesses and the INS business is roughly around a 4%, 4.5% business. So, it's different profile for each piece. It's a big company. We have a lot of different pieces, but just trying to simplify it for you. It will modulate to 3.5%-plus.

Craig Hettenbach - Goldman Sachs

Okay. We have time for one last question.

Unidentified Analyst

I just want to simplify that a little more then. So, you're targeting 3.5% to 4%.Your 30% low-margin mix target, what margin do you figure overall that that part of the business will earn?

Paul Read

The 30% should earn roughly 2%.

Unidentified Analyst

And then I do the math on the other 70%, I can't do that in my head it all for 3.5%, is that right?

Paul Read

The other 70% is not an average of 3.5%, no.

Unidentified Analyst

No, no, 100% is going to average to 3.5% or better.

Paul Read

Yes. Right.

Unidentified Analyst

So, 30 percentage points sort of that's going to be 2 and then the balance will be something else. That's an equation I can't solve in my head, but am I on the right path?

Paul Read

Yes.

Unidentified Analyst

Okay.

Paul Read

Yes.

Unidentified Analyst

Okay. That's very helpful. And then regarding the payout dividends you said, I was a little confused. It sounded like you said, well, you've got some buyback authorization remaining, but you don't figure on being a serial share re-purchaser. And then you said, at least my notes say, maybe you didn't say this, so I misinterpreted that you might pay dividend if the stock goes up. So, can you clarify, do you intend to use up the rest of your buyback authorization if the stock remains here, and is there a time frame or other sort

Of milestone that we can look for as far as the company paying a dividend?

Paul Read

Yes, we find that at the current stock price which roughly is $6 P/E to be very attractive and accretive use of the cash. And so, that's how we look at that. I was trying to address the question with regards to dividends that with the strong free cash flow that we have and with a P/E that's average in the industry, when we get there the alternative use of cash is going to be something like a dividend. And that is that we pay more attention through these days and think more about than we have done over the past few years, but it's something that probably doesn't belong in the fiscal '13 for us, I think probably belongs just outside of that would be the way we think about it today.

Craig Hettenbach - Goldman Sachs

Thanks. Thanks, everyone for the questions and thanks very much for your time, Paul.

Paul Read

Yes. Thank you, Craig. Appreciate it. Thanks, everybody.

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