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Sanmina-SCI Corp. (NASDAQ:SANM)

JP Morgan Global Technology Media and Telecom Conference

May 15, 2012, 1:30 p.m. ET

Executives

Bob Eulau – Chief Financial Officer

Analysts

Mark Strauss – JPMorgan

Mark Strauss

Good afternoon. Thank you everyone for coming. My name is Mark Strauss. I cover Applied and Emerging Tech here at JP Morgan, and we are happy to have Bob Eulau from Sanmina joining us. The firm doesn’t currently cover the stock, so I’m going to assume that some of you, like me, are learning, kind of just getting to know the story, so Bob, do you want to spend three or four minutes just briefly describing your business, maybe going through your end markets or segments?

Bob Eulau

Sure, and first, Mark, thanks to you and JP Morgan for having us here today, we really appreciate it. Sanmina-SCI has been around since 1980, so we’ve been around for 32 years. We operate in 18 different countries, we have in the neighborhood of 42, 43,000 employees, and we’re I think unique within the EMS industry in the sense that we focus almost exclusively on higher-mix manufacturing opportunities, areas in which we can add more engineering content and provide more value to our customers.

And the other area that causes us to be unique is we also have a component and product business that is in the neighborhood of 30% of our overall revenue, and by products and components I’m referring to areas like printed circuit board manufacturing, backplanes, cables, mechanical systems, which includes enclosures and precision machining, plastic injection molding, memory modules, which is an area that we call components but we’re starting to do products in the solid state drive area, and then we also have a product business in the storage area, where we do ODM products intended for other storage companies, and then finally, we have a product business in the defense area, which we’ve been in for through SCI, we’ve been involved with for about 50 years.

So we think we’ve got a pretty diverse set of manufacturing services that we can offer, coupled with components and products that are unique in the industry. We focus on vertical markets that you might expect given our high mix emphasis. One area that’s about 45, 50% of the company is communications, and within communications we have, we do extensive work in the wireless base station area. We also do a fair amount of optical; I would say among the Tier 1 EMS companies, we have the largest optical footprint.

We also focus on another segment, which we call medical, defense and industrial, which for us is very strategic. Those often times are programs that are suited to our capabilities, where we can add more value due to the complexity and the engineering content. We then have another segment, which we call enterprise computing and storage, where we are, as the name implies, focused on computing solutions, and increasingly over the past few years, putting more emphasis on the storage side, which is going reasonably well.

And then finally, we have a multimedia business which, the largest portion of which is set top boxes, but also includes automotive, which has done well in the last few years, and includes other areas we’ve been diversifying into, including high-end cinematography and areas like casino gaming consoles, any area where we can continue to diversify and has multimedia aspects.

Question-and-Answer Session

Mark Strauss

Okay. So you spoke on your last earnings call, and I think the consensus estimates that are out there are looking for a pretty strong uptick in the back half of this year. What’s driving that? Is that coming from a particular end market, or what kind of visibility do you have into that?

Bob Eulau

Yes, so one of the things that we’ve seen for a while is the second half of the calendar year looks like it’s going to be quite a bit stronger than the first half, and we’ve mentioned that actually in our last two earnings calls. What happens with us is we get a rolling 12-month forecast from our customers, so we have a sense of what they’re expecting to happen in terms of new product introductions, in terms of volumes, et cetera. And what we do is try to transparently provide that to our investment community, and we’ve seen this trend for a while. We’ve also had a challenging last six months, largely due to communications, so we’ve had a period of, I would say sluggishness and even decline on the communications side. We’re expecting in the second half of the calendar year that that situation will get quite a bit better, and barring any new surprises, that’s the way the forecasts look.

Mark Strauss

Okay. So I think that kind of explains communications, but can you maybe go into your other vertical areas and talk about the last six months, the last year or so, and then the outlook?

Bob Eulau

Yes, I can. So, in terms of medical, defense and industrial, as I mentioned, a very strategic area for us. From a defense standpoint, we had a step down in that business last year, actually around this time, and now it has stabilized, it continues to be a very profitable business for us, and we’ve got a new leadership team there. We’re optimistic that we should be able to start to see some modest pick-up on the defense side.

Medical is also an important area for us. We focus primarily on larger products, so it’ll be CT scan machines, MRI machines, X-ray machines. It’s a segment in which we can do more vertical integration. We, as I mentioned, have mechanical capability, so we can apply that to a variety of the segments, but particularly in medical. And we see medical as a steady area. There obviously are significant steps you have to take to get qualified to build product in that segment, and we think we’re very well-suited. I’d say that area will be relatively stable, maybe slightly up in the second half.

And then the third area is industrial, and we see industrial as a very promising segment for us. Historically, it’s an area that has been, for us, dominated by the semiconductor capital equipment manufacturers, and as they’ve had a bit of a challenging period here, that has affected that part of the business for us. We’ve, over the years, been diversifying into clean-tech, and we’re broadly looking at industrial. We like industrial a lot because there’s been very little outsourcing at this point, and we think there’s a lot of opportunity as traditional industrial companies look at what they can do from an outsourcing standpoint.

And then the last area for us is multimedia, which was down quite a bit last year, I’m sorry last quarter, it was down about 14, 15%. It was largely driven by the set top box business. We believe that over time we’re going to continue to see a decline there, and it’s not something that is unexpected. We’ve seen it over the last couple years. It was a little more pronounced in the March quarter, we think largely because of the disk drive situation in the prior quarter, which tend to mask some of the demand impact in that quarter. So, we think multimedia, the key there is to continue to diversify and find new areas in which we can add value and help to offset some of the potential declines on the set top box side.

And actually I said that was the last area, I think there is one more, which is enterprise computing and storage. We’re very bullish on the storage side. We over time have seen this segment trend towards, more and more of the products that we’re involved with are on the storage side. We have a reasonable footprint there; we do a fair amount of EMS activity from a storage perspective and then we also have ODM products that we’re selling. Last quarter, we had purchase orders from about 40 different customers on the storage side, and we’re encouraged by that. Most of those purchase orders were related to units for evaluation, but we’re optimistic that in the not-too-distant future we can land some pretty large-volume opportunities there, and we think storage is a very good opportunity for us going forward. So I think in the second half of the year, you’ll see some solid growth on the storage side as well.

Mark Strauss

Got it, okay. And then, over the last few quarters you’ve been pretty diligently paying down your debt. What should we think about that going forward, and what’s your ideal debt profile?

Bob Eulau

Yes, so we’re really proud of what we’ve been able to accomplish on the balance sheet over the last year, and it really started about a year ago when we refinanced some of our outstanding debt, and at the same time paid down some. And then in the last 90 days, we’ve paid down another $250 million in debt. So if you look at that in aggregate, the combination of those two actions, we have reduced our interest expense by about $40 million on an annual basis. So it’s very significant, it’s approaching $.50 a share in terms of interest expense savings. So, our goal all along, and we’ve said this for a couple years, is as we generate cash, and first of all we’ve got to make sure we have the cash to grow the business, and then secondly we will continue to deleverage the company. And our third use of cash will be to do small, tuck-in type acquisitions where something is very synergistic with our existing strategy. In terms of ongoing deleveraging actions, we’ll continue to look for those opportunities. We don’t think we’re done yet. We also don’t think that zero debt is the right answer, so you can expect us to land somewhere between zero and where we are today, but we haven’t put out a specific target and we’ll continue to monitor that. But we’re really pleased with the capital structure. It’s in the best shape it’s been in really in the last decade.

Mark Strauss

Got it. Okay. And then recently your components business has been below average, below corporate average margins. What’s going on there, and what are you doing to get that back in line?

Bob Eulau

Yes, so from a components standpoint again, what we’re talking about when we talk about components is our printed circuit board business, backplanes, cables, mechanical systems, which is precision machining, it’s sheet metal bending and stamping, painting, and plastic injection molding, and memory modules. And we went through several quarters last year in which the combination of those businesses was above the corporate average gross margin, and in the last couple quarters we’ve seen that situation reverse and it’s been below average. The main driver for us at this point has been revenue. When we start to see revenue decline, it has a disproportionate impact on the components business, so one of the things I said in the December earnings call is we had the components business down 17% sequentially, gross profit went down almost 50%. So it gives you an idea of how significant revenue is to the components business. So our goal, of course, is to get the revenue back and, as we get the revenue back, that’s a very high contribution margin area, and we believe it can help the company’s margins very significantly.

Mark Strauss

Okay. And then inventory turns. You have 6.1 last quarter. Do you have a target there? What do you think you can get back to?

Bob Eulau

Yes, so if you look at last year, we ran I think every quarter somewhere between seven and 7.2 turns, and we in the December quarter were at 6.2 turns. We thought that was terrible. I actually did not think it would get worse, and in fact it did get slightly worse in the March quarter, it was 6.1 turns. The short-term goal is to get back to seven as quickly as we can, and I think we’ll start to make some progress there as the business starts to recover and we start to see some revenue growth again. And our longer-term goal is to get to eight turns, which we think is achievable in spite of the high-mix business that we do.

Mark Strauss

Got it. You just talked a little bit about your footprint. So you’re in 18 countries now; are there any regions that you need to expand into, any specific countries?

Bob Eulau

Yes, that’s a good question. If you talk to our operational guys right now, they’re thrilled with our footprint, so to give you a rough idea, we’re about 20% in the United States, about 20% in Mexico, about 25 to 30% in China, and another 20% or so in the rest of Asia, and in the neighborhood of 10% or so in Europe. So we’re very diversified geographically. We’re doing a lot of our business in lower-cost regions of Asia and Mexico, and we’ve got a strategy that really leverages our presence in North America and Europe and allows us to capitalize on our capabilities in Asia. So the strategy is to be close to the customer, working with them through new product introductions, and as the ramp begins, help them transition the products to one of our lower-cost facilities.

Mark Strauss

Got it. Okay, so you’re, you spoke about investing in China and India, expanding in a couple plants there. What do those plants do, and why are you making this investment?

Bob Eulau

Right. So we’re completing this quarter two buildings. One is in China, that is for the printed circuit board business, and it’s really to expand our capacity and capability in China and position us to take on more business in that country. And then the other expansion is in India, which is another building we’re doing there in support of our traditional EMS business. And that’s to provide services to a particular customer who wants us to do more there.

Mark Strauss

Got it. Okay. Does anyone in the audience have any questions? Go ahead, sir.

Bob Eulau

They probably want you to grab a microphone.

[Unidentified Analyst]

Right. You called some of this debt here recently, mainly out of cash, your heavy cash balances. Do you guys, and maybe your EBITDA slipped a little bit, but do you have a leverage target? I know you said you didn’t have a, you wanted, that was one of your primary uses of cash, but do you have a leverage target that you’re going to be comfortable with, and how much cash do you want to keep on the balance sheet to maybe make some of these tuck-in acquisitions?

Bob Eulau

Yes, that’s a very good question. Unfortunately, both questions are ones that we haven’t articulated specific targets on. The leverage ratio’s in fantastic shape, as you noted. EBITDA is still pretty strong; it’s backed up a little bit in the last three to six months, but still very strong, so the leverage is the lowest it’s been in, probably in a decade. So I think from an overall capital structure standpoint, we’re in great shape. From a cash standpoint, we’re also really well-positioned. We have a lot of our cash, I think last quarter it was roughly 50% of it, was in the United States, so it’s well-positioned to use for purposes like paying down debt if that ends up making sense. And we also, to help facilitate that, we’ve done a pretty significant financial re-engineering of the company, where to take advantage of the net operating losses we have in the United States, we’re driving as much profit as we legally can back to the U.S., which is actually the opposite strategy of most companies. So our strategy is all-around bringing as much profit to the U.S., and that has the other synergistic impact of bringing cash back to the U.S. So we’re really pleased with how things are operating financially right now, through the structure we’ve got in place coupled with what we’ve been able to accomplish on the balance sheet, I think we’re really well-positioned. So we don’t have a particular cash target, but we’re obviously really comfortable with where we’re at. From a liquidity standpoint, we’re in great shape. We just redid our asset back-lending facility as well, for another five-year term, so I’d say from a liquidity standpoint, we’re in as good a shape as we’ve ever been in, and from a leverage standpoint, we’re absolutely in the best shape we’ve been in in the last 10 years or so.

[Unidentified Analyst]

So let me kind of, let me ask a follow-on to that more strategically. I mean, Sanmina kind of had a high-mix business, that’s kind of what they came out with the backplanes and PCB fab, and they went in and kind of at the peak bought SCI, which is a high-volume shop, and now it seems like you’re back to square one a decade later. So, are there more, some of these things kind of stick out in here, like the set top box business and maybe some of the components business. Is there some stuff that still probably needs to be refined in your portfolio that you maybe want to divest, or maybe something you want to pick up to kind of make your model work a little better?

Bob Eulau

Yes. So, good questions. And first of all, I think that’s a good observation. I’ve been with the company for three years or so, and I think Jure Sola, our CEO, and the management team, the board, made a very bold decision about five years ago to divest out of the personal computer manufacturing, which was one of the reasons why that merger happened to begin with, between Sanmina and SCI.

So, it’s not often that a company has the courage to make the decision to shed five or $6 billion of revenue in order to focus on a strategy that’s inherently consistent, like going after high-mix customers where you can do more vertical integration, take advantage of the component capabilities. So, from a strategy standpoint, I don’t see us really making any changes. I would say that one of the other challenges over the last decade was the footprint, and after that merger we had too much capability in the U.S. and Europe and we had to get that properly positioned in other low-cost areas around the world.

I think that’s, as I mentioned earlier, that’s largely completed, so I think the footprint’s really in excellent shape. After we reestablished the footprint, of course, then there were learning curve effects and so we had to improve execution in a few areas. I think that is largely behind us, and we really feel like now the key is growing the revenue.

We like the strategy, we like the businesses we’re participating in, and it’s a matter of continuing to grow the revenue and demonstrate the margin capability of our company. And we need to do a good job of articulating that. We’re not your ordinary EMS company, particularly with the mix we’re focused on coupled with the component and product businesses that we have, and so we’ve got to do a better job of executing it and demonstrating our capability.

Mark Strauss

Go ahead, sir.

[Unidentified Analyst]

Thank you. You mentioned sluggishness in the communications business. I was wondering if you could get a little more specific on where the sluggishness has been and then translate that to the expectations for a better second half. Is it in the same areas? In other words, are we just seeing delays and [inaudible] starting to kick in or is there sluggishness in one area and you know, the second half optimism is in another area?

Bob Eulau

Yes, so good question. And you’re right, we’ve been through a challenging six-month period on the communication side. It’s been largely driven by bay stations or cellular wireless access. It’s been an area that’s been challenged. We do expect that area to start to improve this quarter and to be significantly better in the second half of the calendar year. And that, I would say, is the driving force in terms of the challenges we’ve had on the communication side.

We did have some softness on the optical side, but that is also getting better this quarter and looks more promising in the second half of the year. So it’s – I would say those are probably the two key areas in communications. But by far, the bay station area was the most significant one.

[Unidentified Analyst]

And then automotive, you mentioned is a sector. You didn’t really talk much about that in terms of outlook. Maybe just a couple comments there?

Bob Eulau

Yes, so automotive, we have in our multimedia segment because what we do there is largely communication console business for – obviously, for vehicles. And it’s, over the last couple of years, been a very strong growth area for us and we anticipate to see, you know, maybe not quite as strong, but continue to see pretty significant growth on the automotive side. So we, you know, we’ve got some great customers there. And as most people know, that market’s doing reasonably well right now.

[Unidentified Analyst]

Hi. Can you talk a little bit about how you’ve managed inventories during the downturn last year, and you know, now that we’re entering an upturn in the second half, you know, how you think about, you know, build patterns and maybe carrying a little more inventory here in the second half to support the higher demand?

Bob Eulau

Yes. So I mean, inventory is always a challenging area, particularly in our business. In the EMS space, it’s different than a typical product company though. It’s – the inventory is largely committed to by the customer. So it’s, you know, we don’t have exposure for excess or obsolete inventory when we’re providing the manufacturing services. For our component and product businesses, we still have that risk but from an EMS standpoint, we really don’t. And that’s – and I believe that’s the case with all of our – at least most of our competition if not all of our competition. So that’s one thing you’ve got to keep in mind when you worry about inventory in our industry.

In terms of inventory levels, I mean, we’re pretty disappointed in the last six months and it’s a challenge when business decelerates, it’s a challenge to get the inventory off the balance sheet as quickly as we would like. And while I said, we don’t have excess or obsolete inventory we’re going to be writing off, it does consume our working capital. And so, we’re very interested in improving the turns. I talked about that earlier. If we can get the turns up – if we can get the turns back up to seven, we’re at 6.1 today, one turn in inventory is about $100 million in cash. So we have a lot of cash tied up inventory right now and we could do more, obviously, on the capital structure side if we could get confident in our inventory balances going forward.

So I don’t really see a need to increase inventory as we grow the business in the second half of the year. I think we need to increase the inventory turns and use the inventory we have more productively. And that’s exactly what our goal is.

[Unidentified Analyst]

And the wireless access products, you know, have been soft. What’s going on there and when can we expect to see an inflation?

Bob Eulau

Yes, so it’s – as I mentioned, I mean, that’s been the key area of weakness over the last six months for us. We don’t know, for sure, what caused that. You know, the best analysis we’ve been able to see is it largely started with the – the potential transaction between AT&T and T-Mobile and that froze some of the capital equipment spending. Once those guys stopped investing, then their competition could as well. So there was this general freezing of infrastructure deployment.

So, that started in, you know, back last fall, and we had – if you look at our numbers, you’ll see that there’s a very abrupt change in revenue for us. We did about 1.7 billion in the September quarter, and went down to 1.5 billion in the December quarter. So it changed very rapidly.

And we think, again, the real cause was that potential transaction, and once that happens then the equipment companies are burning off their inventory – we’ve gone through – we think that period of the last six months, and at this point we think their inventory levels are probably at an equilibrium, and so the opportunity for us now is to grow as demand comes back. We’re seeing in the June quarter, we’re expecting to see some pick up on the wireless access side and we expect, as I said earlier, to see more strength in the second half of the calendar year.

Mark Strauss – JP Morgan

Got it, okay, and then you guys are working on a storage product that you got beta’s going on with a couple of customers, what exactly is this, how’s the process going, is this contributing to revenue?

Bob Eulau

Yes, so, great question. As I mentioned – I mean, storage is becoming the majority share of the enterprise computing and storage segment for us. We’ve been investing in ODM products there for the last – probably last two years at this point, and we’re having a lot of evaluation going on with customers – I think I mentioned that last quarter we had about – we had purchase orders from about 40 different customers. Most of that was for evaluation, not for production, but that’s a very good sign that we’ve got that much evaluation going on with the products, and we’re hoping in the not too distant future we can land a few of the higher volume customers, and that would really help us with that segment, and we’re very blush on storage going forwards, it’s a relatively small business, but already a profitable business for us. And so, if we could get some growth going there that would be very helpful for us overall.

Mark Strauss – JP Morgan

Got it, okay. Any other questions? Okay. I think we’ll wrap it up. Thank you.

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