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Flextronics International Ltd. (NASDAQ:FLEX)

F1Q09 Earnings Call

July 24, 2008 5:30 pm ET

Executives

 

Michael McNamara – Chief Executive Officer

Paul Read – Chief Financial Officer

Warren Ligan – Senior Vice President of Investor Relations

 

Analysts

 

Amit Daryanani - RBC Capital Markets

Brian White - Collins Stewart

Alexander Blanton - Ingalls & Snyder

Kevin Kessel - JPMorgan

William Stein – Credit Suisse

Jim Suva - Citigroup

Louis Miscioscia - Cowen

 

 

Operator

Good afternoon and welcome to the Flextronics first quarter fiscal year 2009 earnings conference call. (Operator Instructions) At this time I would now like to turn the call over to Mr. Warren Ligan.

Warren Ligan

Thank you, operator. Good afternoon ladies and gentlemen; thank you for joining us today for our quarterly conference call to discuss the results of Flextronics’s first quarter ended June 27, 2008.

To help communicate the data on this call, you can also view a presentation on the Internet. Please go to the Investors’ section of our website and select Calls and Presentations. You will then click through the slides; we will give you the slide number we are referring to.

On the call today is our Chief Executive Officer, Mike McNamara, and our Chief Financial Officer, Paul Read. Mr. Read was appointed Chief Financial Officer effective July 1, 2008 upon Tom Smach’s departure as announced in our press release dated May 16, 2008.

Paul most recently served as Executive Vice President of Finance for Flextronics’ worldwide operations.

I will turn the first part of the call over to Paul to go through the financial portion of our prepared remarks. Mike will then give his view on the quarter and provide guidance for the upcoming quarter. After Mike’s comments have concluded, we will open our call to your questions.

Please turn to slide 2. Please note that this conference call contains forward-looking statements within the meaning U.S. securities law, including statements related to:

Revenue and earnings guidance;

Future revenue and earnings growth;

Expected improvement in operating margin, future cash flows, ROIC, and SG&A expense levels;

Our expectation of continued growth in the current economic environment;

The expected benefits resulting from our geographically diversified business and our broad based products, services, and component technologies offerings;

The expected benefits from our acquisition and long-term investment strategy;

And our expectation of the benefits, cost savings, and revenues to be obtained from the Solectron acquisition.

These forward-looking statements involve risk and uncertainty that could cause the actual results to differ materially from those anticipated by these statements. Information about these risks is noted in the earnings press release on slide 14 of this presentation and in the Risk Factors and MD&A section 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 statements. Investors are cautioned not to 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 to the earnings press release, slide 7 of the presentation, and the GAAP versus non-GAAP reconciliation in the Investors’ section of our website, which contain the reconciliation to the most directly comparable GAAP results.

At this time, I’d like to turn the call over to Paul for his comments.

Paul Read

Thanks, Warren, and good afternoon everyone. Please turn to slide 3 in the presentation. Our first quarter revenue increased 62% from the year ago quarter to a record first quarter high of $8.35 billion, while quarterly adjusted operating increased 83% from the year ago quarter to a first quarter record high of $280 million.

Please turn to slide 4. We grew our quarterly revenue for each of our segments on a year-over-year basis. Revenue from the Infrastructure segment comprised 35% of total revenue and at $2.9 billion, represents an increase of 100% over the year ago quarter.

Revenue from the Computing segment comprised 17% of total June quarterly revenue and increased 195% from the year ago quarter. The Consumer Digital and Mobile segments comprised 14% and 19% of revenue for the quarter respectively.

While both segments were flat to slightly up in revenues from the year ago quarter, their combined total quarterly revenue is approximately one-third of our total revenue, which is down from one-half of our total quarterly revenues a year ago, reflecting a more balanced end market diversification.

Finally, the Industrial, Automotive, Medical, and Other segments comprised 15% of total revenue and increased 119% over the year ago quarter. These segments now represent approximately $1.3 billion in quarterly revenues. The strength and growth of this segment is significant and will continue to be a growth driver for us in the coming years.

Our top ten customers accounted for approximately 55% of revenues in the June quarter, and Sony Ericsson was the only customer that exceeded 10% of the June quarter revenues.

We realize these numbers are difficult to analyze on a year-over-year comparison. In general, we expect to see our organic revenue growth to be in the range of $2 billion to $3 billion this year after we exclude the contributions of the various acquisitions.

Please turn to slide 5. Adjusted gross profit of $507 million and adjusted operating profit of $280 million established record first quarter highs, increasing 74% and 83% respectively from the year ago quarter.

On a margin basis, both adjusted gross margin and adjusted operating margin improved year over year by 40 basis points, with adjusted gross margin amounting to 6.1% and adjusted operating margin amounting to 3.4%.

Please turn to slide 6. Adjusted net income amounted to $227 million, which represents a 69% increase over the year ago quarter and is a new first quarter all-time high. This resulted in the first quarter adjusted earnings per diluted share of $0.27, which is a 23% increase over the year ago quarter.

Please turn to slide 7 for our quarterly GAAP reconciliation. During the June 2008 quarter, the company recognized after-tax intangible amortization and stock-based compensation of approximately $23 million and $15 million respectively, compared to $17 million and $9 million respectively in the year ago quarter.

Also during the June 2008 quarter, the company recognized after-tax restructuring integration and other charges of approximately $58 million, primarily related to restructuring and integration activities associated with the Solectron acquisition.

These represent the final restructuring costs associated with the acquisition, and the company expects to be able to absorb any future restructuring charges in its quarterly operating results or offset them with one-time gains in the period.

After reflecting these items, GAAP net income increased by 22% to $130 million compared to $107 million in the year ago quarter. GAAP earnings per diluted share were $0.16.

Please turn to slide 8. We have been consistently building on our operational success and that has been reflected in our steady improvement in return on invested capital. This quarter, return on invested capital improved 30 basis points to 10.7% from 10.4% in the year ago quarter.

Please turn to slide 9. We ended the quarter with $1.8 billion in cash, which is a sequential increase of $42 million from the last quarter. Total debt was $3.7 billion at quarter end.

Net debt, which is total debt less total cash, amounted to $2 billion at quarter end. Including the availability under our revolving credit facility, total liquidity was approximately $3.3 billion and our debt to capital ratio was 31%.

Please turn to slide 10. Our cash conversion cycle increased slightly to 26 days from 25 days last quarter. Our inventory turns improved to 7.3 turns in the June quarter from 7 turns in the March quarter.

Our inventory balance increased by $337 million, which reflects the impact of acquisitions made during the quarter and the positioning of inventory to support new business ramps.

Days sales outstanding improved 1 day sequentially to 41 days while days payable outstanding decreased 5 days sequentially to 65 days.

We continue to focus our efforts on our working capital management and expect to generate additional cash flow while improving our working capital metrics.

Please turn to slide 11. Our cash flow from operating activities reflected the use of $8 million during the quarter, which included approximately $150 million of spend associated with our restructuring and integration-related activities.

CapEx amounted to $155 million while depreciation and amortization totaled $117 million for the quarter. As a result, free cash flow was negative $163 million.

Thank you, ladies and gentlemen. As you turn to slide 12, I will now turn the call over to Mike McNamara.

Michael McNamara

Thanks Paul. I would like to begin by highlighting that I am very pleased with our execution this past quarter, especially in light of the challenging economic environment. Our June quarter revenues of $8.35 billion and our adjusted EPS of $0.27 were both within the range of our quarterly guidance.

Our revenues continue to be solid. Currently, any softness in revenue is being overcome though new customer wins or new product categories adding additional business. Clearly, we are operating in a very challenging marketplace, and several trends are emerging simultaneously, which makes it difficult to assess the market and to conclude on the strength of the overall demand environment.

While there are areas of softness in certain markets and geographic regions, there are also various product categories where demand is strong and certain regions where most segments have strong revenue growth. Additionally, some segments have customers doing well and others not so well.

So the answer to the question of ‘how is demand?’ is, it just depends. It depends on the segment; it depends on the region, and it depends on the customer. However, being an Electronic Manufacturing Services company and not an OEM, we still see the EMS business expanding during this time of economic uncertainty.

The cost side is also becoming more challenging. We are seeing an escalation of costs that are more significant than we have seen in many years. In particular, we are seeing cost pressures in many commodities, foreign exchange rates, labor rates, energy costs, and freight costs.

We are working hard to mitigate these costs. We have increased our efforts to drive down SG&A. We have accelerated efficiency improvements, and we are educating our customers on the changing cost environment.

While we have very strong year-on-year margin improvement, these conditions are impacting our ability to improve our margins as quickly as we would have hoped.

These are exceptionally challenging times that will cause our customers to rethink their worldwide supply chain strategies, and we believe Flextronics will be a prime beneficiary of these new strategies due to our global scale and breadth of service offering in so many different geographies.

We also are very well prepared for this macroeconomic environment as the expansion of our segments have created a much more diversified company and one that can weather the macroeconomic disruptions much more successfully.

An example of this expansion is seen in our Computing segment. During the past quarter, we completed the final phase of the previously announced Arima acquisition. We are extremely pleased with the level of interest and business opportunities we are seeing from Tier 1 OEMs that seek to leverage our design and manufacturing capabilities in this rapidly growing market.

This is evidenced through our recent announcement of a design and manufacturing win for a new high volume notebook computer for HP. This market continues to grow very rapidly, and at over $100 billion, it is the largest outsourced market in the world today.

As a result, we are significantly increasing our design capability to develop new platforms. While this adds to our cost pressure in the near term, it positions this product category to be a significant contributor of revenue growth over the next several years.

We have also enhanced our capabilities in our Consumer Digital business through the addition of significant capacity to design and produce flat-panel LCD televisions.

Our Mobile segment grew its revenues 11% sequentially. While certain customers experienced softness in demand, we were still able to show good growth through our continually more diversified customer base.

Our Medical business is shaping up to be a superb growth engine, with a very broad customer base and a very broad product offering. We recently completed the acquisition of Avail that added non-electronic disposable medical device products to our portfolio and we are on track to once again achieve our cost synergies.

We completed the acquisition of FRIWO, which primarily focused on chargers and have already booked major contracts with multiple new Tier 1 OEMs.

A very important achievement this quarter is that it is the final period in which our results will be negatively impacted by the associated restructuring and integration-related charges of the Solectron acquisition.

I’m extremely proud of the entire organization for their diligent efforts in completing the integration and achieving this financial milestone in nine months. There are no more charges expected from this acquisition.

Lastly, at our Analyst Day last November, we shared with you our expectations of the improving cash flow of our company. We continue to believe the company will generate significant cash flow in the current and future years.

We believe it was important to fully integrate the recent acquisitions before committing to a course of action to utilize a portion of this excess cash. We presently have Board and shareholder approval to buy up to 10% of our ordinary shares.

Shares repurchased under this plan may be made through a variety of methods, and the timing and actual number of shares repurchased will depend on a variety of factors, including share price, corporate and regulatory requirements, and other market and economic conditions.

With this authorization, we will continue to allocate our capital in a manner that we believe is best for the business. We will continue to invest back in the business, pay down debt, and/or buy back stock.

I would next like to share our guidance for the September quarter. Please turn to slide 13. We expect September quarter revenue to be between $8.5 and $9 billion and adjusted EPS in the range of $0.28 to $0.31 a share.

We would like to reiterate that our September quarter visibility is always limited as the quarter is traditionally back-end loaded due to summer holidays in July and August. Our guidance also reflects some consideration of the challenging macroeconomic environment.

This guidance reflects an EPS increase over last year of between 17% and 29%. Quarterly GAAP earnings per diluted share are expected to be lower than the guidance provided herein by approximately $0.05 per quarter for intangible amortization expense and stock-based compensation expense.

I want to remind everybody that during our January earnings call, we cautioned that there would be insider selling during the first half of this calendar year. Part of our stock-based compensation includes restricted stock grants to executive officers that began to vest in April and May 2008.

This would result in some insider selling under 10b5-1 plans and it should be not interpreted as an indication of insider views on valuation or outlook. It is insiders monitoring the shares to pay the related income tax resulting from the vesting of restricted shares. You should expect the same activity to occur in April and May of 2009.

Finally, on behalf of the entire management team, I would like to thank our employees around the world for their continued hard work and dedication in a very rapidly changing market environment. We are very confident in Flextronics’ strong position and look forward to the exciting opportunities in front of us.

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

Your first question comes from the line of Louis Miscioscia - Cowen.

Louis Miscioscia - Cowen

Mike, maybe you can just help us out with the share buyback. How did you all come to that conclusion and would you expect to be reasonably aggressive at these levels here?

Michael McNamara

The conclusion was to get us into position where we had maximum flexibility to allocate our capital in the best way that we saw fit. When I say that, I mean it could be anything from reducing our debt to buying back shares or obviously continuing to invest in the business.

When we look forward, we see that we have most of the pieces that we need in our company to compete long term. As you know, we have continued to invest in the company very aggressively in terms of new capabilities, in terms of expanding our footprint, in terms of expanding some of our product categories; diversifying into product categories that we didn’t participate in in the past.

Most of those activities are really done. So we have put ourselves in a position where we believe we have made the major investments necessary to maintain a very, very broad-based portfolio that compete over time and really sustain for a long period of time.

We also look at the fact that we’re starting to move margins up; our profitability has been pretty solid. We are predictably earning. We actually expect to generate a lot of excess cash.

When we look around at what we are going to do with that, we think buying back stock is one option that we have as a result of the price that we have today, but also as well as a good governance program to possibly continually reduce the amount of total shares outstanding over a long period of time.

We just want to put ourselves into having the right flexibility and really the opportunity to take advantage of anything that we need to.

As far as how aggressive we’re going to go at it and how soon, it really depends. We have to look at the market. It’s a tough one to judge right now. We do view our stock as being attractive at these levels. Again, it depends on how much cash we really have available. We’ll just put it all together and then make that decision as time goes on.

Louis Miscioscia - Cowen

Okay. When we look towards your earnings guidance that you had given back in November of $1.20 to $1.30, with the way it looks like, the September quarter might be a couple of pennies light, maybe a little bit of a hangover into December. Do you think that it’s around $1.20 is the thought now, or do you think that there is a whole new range here?

Michael McNamara

Certainly a lot has happened since November. As you know, that November was guidance for a year that started in April. I would like to reiterate, those were our targets of what we thought we could achieve at that time, but our real guidance is only a quarter in advance. I just wanted to restate that position.

But as we look at that, a lot has changed since then. Oil was probably at $90 a barrel back at that time. The Dow was probably 15% or 20% higher. The macroeconomics didn’t look as bad. So there is a lot that has happened between then.

Alternatively, when we set those targets, we thought they were achievable. We knew the economy was a little bit rocky even at that point. So we still hold those targets as how we are driving our management team and our group.

Certainly, as we think about that range, we expect to be a little bit on the low end of that range as opposed to the high-end of the range, of course.

I think the only new data here is the economy has changed a lot, as I mentioned. The cost increases are continually more challenging for us. The macroeconomic has certainly deteriorated since last November. Certainly while we are still looking to hit those targets and not reset, we certainly would expect to be at the low end.

Louis Miscioscia - Cowen

Okay, and then a final quick question is, on the HP notebook win, congratulations on that. Can you give us any help on the size and the timing of that? Thank you.

Michael McNamara

Not really; sorry about that. I am talking about just generically as opposed to this particular one; but if you just think about that win in and amongst itself, most of the launches after a win will hit in about nine months. I’m using very generic numbers as opposed to specifically the HP one.

In some cases, we don’t know how big it’s exactly going to be, but it is a high volume notebook. So I would call it sizeable. But we’re not at liberty to disclose the actual amounts except to say the important part here is to get the nod from HP is very important, a sign of confidence.

Secondarily, not to get a niche notebook, but a mainstream notebook is also a very significant sign of confidence. So I think the takeaway here is that we’ve been able to put together a portfolio of capability and be able to convince at least HP that they can go risk some of their high volume products then with us. That realization that HP had is going to extend across to all the Tier 1 OEMs.

Louis Miscioscia - Cowen

Okay, thank you.

Operator

Our next question comes from Jim Suva - Citigroup.

Jim Suva - Citigroup

When we look at the stock buyback, those of us who have been following this company for a while have heard this before. I know you weren’t calling the shots back then. But back at about 2 – 2.5 years ago, you announced a $250 million stock buyback.

The question now is how credible is this 10% you are putting out there for us. Also more importantly, when we look at you making a decision about that say versus acquisitions; the entire group has been under tremendous pressures.

One can’t help but think some more acquisitions because, hats off to you, Solectron integration was much better than expected. Why not put that at a higher priority versus a buyback?

Michael McNamara

Again, our key position here is to put ourselves into a position to be able to do the buyback, investment in the business, the acquisition, whatever makes sense. When we look at our business and we look at where the acquisition investments have gone, we’ve obviously had a lot of success in some of these acquisitions.

When we look at the pieces we have in place, the completeness of the product portfolio, the amount of verticals that we’ve invested in, the need for acquisition has deteriorated significantly.

You look at the fact that we are continuing to grow organically very nicely. The range I think Lou mentioned a minute ago was – maybe he didn’t mention it – but it was like $34.5 to $36.5 billion. We certainly have adequate size and scale to last.

The real thinking on being able to introduce the stock buyback is that we just don’t need a lot of acquisitions to have a complete portfolio. Two-and-a-half years ago, I don’t even remember, to tell you the truth; it wasn’t my call to decide to go after that, or I don’t know exactly all the dynamics of what went into that decision. But we for sure were not at a position where our footprint was exactly correct.

We for sure were underinvested in many of the vertical technologies, and in fact, even our company size was pretty much at par with Solectron and Sanmina at that time. I think there was a lot more work to be done to develop a position that was very sustainable over time and very competitive in the marketplace. I don’t think we were ready back then for that.

But as we look now, we have higher profitability, which is going to generate more cash. We have the footprint we want. We don’t have to do those acquisitions. I actually think we are more in a position to do it today. I don’t think we were 2.5 years ago.

But again, I don’t know all the decisions that went into the criteria to either do it or not do it that last period. But certainly, as we look at our portfolio capability and our cash flow now, we think it’s absolutely a very profitable solution for us.

Jim Suva - Citigroup

So if I look at the acquisition need as deteriorated because Solectron has done so well and where your stock is today, would it be fair to say that where we sit from today, what we know now, that buyback just looks more attractive than acquisitions or is it just pray that the cash comes in the door and opportunities?

Michael McNamara

I don’t think you have to just think about the acquisition being Solectron. If you just think over the last couple of years, we have added LCD displays. We have added machining technologies, which we never had before.

We think our Power System group could actually go up as high as $1 billion in the next two years. We have added disposable medical products. We have added plastics factories for Medical. We have expanded into the whole computing space. All of those things and all those pieces are outside of the Solectron acquisition.

I think Solectron helped in the high-end. It helped going after the high-end computing and telecom space, and it helped with the Services business and it helped diversify our portfolio away from consumer electronics.

I think we mentioned we went from 50% to close to 33% year-on-year. I think that’s going to help us as we go through the consumer slowdown that’s inevitable; going to gain some speed here over the coming quarters.

So I think it’s more than just Solectron and putting that behind us. I actually think it’s the breadth of all these different pieces that we’ve put together over the last two years. Now I think we can really lock and load and make that work for us a little bit better with a focus of driving more margins because our investment is going to need to be less.

As we drive more margins, we are going to drive more cash flow and it I think it makes the share purchase a real good choice.

Jim Suva - Citigroup

And a housekeeping item, CapEx for fiscal 2008 that we should plan on and cash flow from ops?

Michael McNamara

You mean in fiscal 2009?

Jim Suva - Citigroup

Sorry, 2009.

Michael McNamara

We are still hoping to do about $400 to $450 million. We think it’s going to be roughly equivalent to our depreciation levels or maybe at $50 million high. We are in a little bit of a heavy investment period right now, which we are going to see all the time, which is to prepare for the September to December increase that we typically see, the seasonal increase.

We’re going to be pretty close to that depreciation level, although we are running a little bit hot right now because we have a lot of opportunities. But we still think it’s going to come in either at depreciation levels or plus $50 million.

Jim Suva - Citigroup

Thank you very much.

Operator

Our next question is from Will Stein - Credit Suisse.

William Stein – Credit Suisse

I don’t mean to beat the stock buyback to death, but I think the issue last time, at least as I recall, it was less about the operating situation of the company. It was more about some laws of Singapore, where your legal domicile is.

Can you update us on that? Is there any reason that we wouldn’t see a buyback actually happen as opposed to just the announcement?

Paul Read

We have obviously gone through evaluating all the options here with regards to stock buyback. We are certainly restricted under Singapore law for certain purchase methods. However, we are very clear on what we need to do and how we need to do it. So we have everything lined up.

Obviously getting the Board of Directors’ approval was important for us. So it will be part of this fiscal ’09; timing and quantity and price et cetera to be determined. But there are no roadblocks to doing it.

William Stein – Credit Suisse

What’s the expiration of the authorization?

Paul Read

We have authorization from the shareholders and the Board for a 10% purchase of outstanding shares as at last year end. We have an AGM on September 30 where we will ask for that to be reapproved, which would be at the higher level of shares, of course, and the Board have already given approval should that be reapproved by the shareholders, which we would expect. Therefore, this would last through the following September 2009.

William Stein – Credit Suisse

So it’s year by year?

Paul Read

Yes, you have to get shareholder approval year by year.

William Stein – Credit Suisse

Okay. And then if I can turn to margins for a second; it seems as though the margin improvement, while very nice year over year, seemed to have stalled in the quarter a little bit. I’m hearing you talk about higher costs for materials and shipping expenses and oil and all that; energy I suppose.

Can you help us understand what portion of these costs are things that are directly passed on to customers in the bill of materials or in the bill that you hand to customers versus things that you take risk on yourselves?

Michael McNamara

I could tell you certainly the objective is to pass 100% of those costs on to the customers. So when we do our pricing and when we work with our customer on what the right price is for a particular product, we talk about the bill of materials and we also talk about the drivers of all the cost; of all the value-added pieces of the cost to produce the product.

It’s our objective to get all these costs in. So it never our objective to absorb energy costs as they continue to increase, to absorb currency fluctuations. It’s not our objective or expectation or even our customers’ expectation for freight or any of these.

The issue is the timing by which these costs go up, how fast you can get them into the product price, and whether or not there is a delay for the customer and whether or not you have either contractual rights to change them or you have negotiation possibilities to go change them or whether you have to wait for the next product release to incorporate those costs into it.

But it’s our intention to absorb nothing. You can’t do it day one. It’s hard to tell the customer that you are going to raise prices next quarter because oil may go to 160 a barrel instead of 130. It’s just hard to have that conversation.

There is a little bit of a lag effect. We are certainly feeling the effects of that lag effect, but at the same time, we are aggressively trying to go figure out how to go mitigate those costs and we’re aggressively trying to figure out, for those costs that we can’t mitigate, how to pass those on to the customer.

William Stein – Credit Suisse

Okay, so along those lines, I understand it’s not guidance, but targets would have suggested about 3.8% operating margin this year. I am wondering if we assume that commodities don’t continue to run, if we make that bold assumption, do you still think you can get close to that or has something changed? At the current level, can that not be passed on fast enough to get to that level?

Michael McNamara

Again, 3.8% is one thing. I think the way to think about it is our margins are always dependent on what kind of business we are bringing in. I think, as you know, we always try to say we drive to a certain return on capital target on that incremental new business. So if the cell phones come in, it’s coming in at a whole different price structure than a complex infrastructure product.

That being said, we have a pretty good idea of what our mix is. I think the way to think about it is we expect to be able to run this business between 3.5 and 4%, and that expectation is even in light of the current cost challenges that we are having.

I think it’s slowing us down a little bit in terms of getting there. I think if these costs weren’t as aggressively going up, I think we’d be at higher than a 3.4% number today.

But nonetheless, we have line of sight of how we can drive our margins forward from the 3.4% and we think we can comfortably run in the range of 3.5 to 4% over the near term. I think that’s the way to think about it. 3.8% is in the middle of there.

William Stein – Credit Suisse

Great, thank you very much.

Operator

Our next question comes from Kevin Kessel - JPMorgan.

Kevin Kessel - JPMorgan

Great, thank you very much. I just wanted to go back again to that cash flow question earlier. I think, Mike, you said CapEx was expected around $400 to $450 million. But it seems like it has clearly been somewhat front-end loaded so far in the fiscal year, with this quarter at a little over $150 million.

From what I recall previously, I thought that you had outlined cash flow of $1.2 billion, and that would result in about free cash of $800, assuming a $400 million CapEx. Is that still something that we should think about as what the objective is for fiscal 2009?

Paul Read

That $800 million had a range around it. It’s definitely our target still for the year. We are not coming off that as our target. All the other pieces that lead up to that are pretty much within range.

CapEx, as you said, is a little bit over compared to depreciation. We got acquisition costs et cetera, one-time charge cost, restructuring. But overall, we are still targeting that number, but given there is a small range around that number for us.

Kevin Kessel - JPMorgan

And what did you say about the quarter? How much were you negatively impacted from cash charges related to restructuring?

Paul Read

It was approximately $150 million.

Kevin Kessel - JPMorgan

In cash charges?

Paul Read

Yes.

Michael McNamara

Yes, cash charges.

Kevin Kessel - JPMorgan

And going forward, you expect no more charges from Solectron on either an accrual basis or cash?

Paul Read

On a cash basis, we still have approximately $200 to $250 million to pay out over the next three quarters. But from an accounting perspective, we are done.

Kevin Kessel - JPMorgan

I got it. Then when I look at the Mobile part of your business, I think it came in quite a bit stronger than people might have thought, up 11%. I know, Mike, you have mentioned that it points to the diversification of that segment aside from just the one 10% customer you have there.

Can you help us understand even in a broad sense roughly how many customers make up that Mobile segment today, and is it just strictly phone customers and potentially smartphone customers that are in there or are there other type of applications that we might not be thinking about that you slot in Mobile?

Michael McNamara

I’m thinking we are shipping anywhere between 9 and 11 different customers in that segment today, I believe. It’s obviously dominated by Sony Ericsson. As you do the numbers, they are a 10% customer, so it continues to be dominated pretty heavily with Sony Ericsson. We do feel the impact of what their numbers are on a large-scale basis.

We are doing smartphones, and I think going forward, we’ll do more and more smartphones as a percent of total only because I think that marketplace is growing, and certainly we will be participating in that growth.

I think, yes, the best way I can describe it is while some customers are going to have some short-term problems, other customers alternatively, we work hard to diversify our customer base and make sure that when one customer is down, hopefully, we bring in another customer that’s going up. Like I said, we do hope to participate in the smartphone market pretty significantly.

Kevin Kessel - JPMorgan

Great. And then just as a housekeeping note, is there any way at all to quantify as a whole what the impact of the rising cost may be in terms of basis points on margin, if we just look at this quarter, for example, relative to maybe what it was a quarter ago or something?

Michael McNamara

It’s a little bit of a tough question, but I think I might take a shot at it. We have rising costs anyway. The euro has been rising against the dollar for years. We have to go figure out how to go deal with it. There are other costs that have been going up. Costs in Asia have been going up for several years as well.

So the question is how much is normal and how much you can mitigate as a normal course of your business in terms of driving efficiency and improvement and how much is excess that you really probably can’t get as a result of purely internal efficiencies and what we are losing in terms of the delay effect in terms of getting it into our product pricing.

I expect this quarter, we have probably been hit maybe 10 to 20 basis points, I would guess. It’s a guess because there is no real right answer. But certainly relative to where we were last quarter to this quarter, I think we are taking about a 10 to 20 basis point hit.

Kevin Kessel - JPMorgan

And this was probably the first quarter that it has jumped up in a significant way, I am assuming, as opposed to just like you said, normal course of action, rising costs that you deal with?

Michael McNamara

That’s correct.

Kevin Kessel - JPMorgan

Okay, thank you very much.

Operator

Your next question is from Alexander Blanton - Ingalls & Snyder.

Alexander Blanton - Ingalls & Snyder

Good afternoon. I’ve got a couple of things. The first one, I want to discuss just briefly the Solectron part of your business. Even though I know you can’t identify it now, because it has been intermingled and so on; you can’t tell us exactly how much it is. It is there.

There is a lot of high-end business there and the most difficult to make Cisco products, the high-end computing at IBM, the NCR ATMs, Trimble Navigation products, and so on. Now that’s a pretty high-end product mix and always has been.

Sanmina reported yesterday, and they have a high-end product mix too, but it’s not really as high as Solectron. They don’t have the high margin service and aftermarket support business either that Solectron does.

But they reported a 7.4% gross margin. This is without the PC business, which they have sold. They had a 4.2% SG&A figure. So that left them with an operating margin of only 3.2%.

But I want you to tell us is there any reason why the Solectron portion of your business, which is anywhere between and $12 and $14 billion annually, can’t get a gross margin ultimately comparable to at least what Sanmina is doing.

They promised a 7.6 to 7.8% next quarter. With your SG&A of say 2.5%, if you can get 7.5 to 8% out of the Solectron business, and you have a 2.5% operating cost to take away from that, that leaves 5 to 5.5% operating margin for that portion of the business.

I don’t think models really have that in there, but if you put that kind of metric into an earnings model for FLEX and look at 2010, you will come up with accretion from the Solectron acquisition of around $0.40.

So if you assume that FLEX by itself without Solectron in the normal course of events would have earned say $1.30 in 2010, if you have $0.40 of accretion from Solectron, you get $1.70.

Could you comment on that as a prospect? I am not saying it should even be a target, but as a prospect?

Michael McNamara

There are a lot of comments, and I’ll try to hit them; try to remember them all. But first thing is we have had Solectron for nine months, and part of getting that gross margin is to get the footprint in the right position and to get the contracts in the right place, and I think we’re taking steps to do that.

I think that’s moving along very effectively. If you think about Solectron being 40% of the total business or so, think about FLEX being at whatever it was – $19 billion when we picked up Solectron, and Solectron being at $12 billion.

FLEX is running at about 5.7% gross margins last year at the same time, and now we are running at 6.1%. We should be able to get that Solectron piece running at a higher level.

Alexander Blanton - Ingalls & Snyder

Yes.

Michael McNamara

Now that doesn’t get it to 7.6% or 7.8%.

Alexander Blanton - Ingalls & Snyder

Sanmina can do that and Solectron has a better manufacturing capability than Sanmina. Solectron’s really the best in the world at making these high-end products. So why can’t they make a margin comparable to Sanmina?

Michael McNamara

Yes, so I’ll keep trying to go through that. I think some of those product categories are just not going to run that high. You talk about kiosks and things like that. Those don’t carry the complexities to carry such a premium. Same thing with Trimble, you mentioned as the other one. I just don’t think they have the complexity to run at that level.

Alexander Blanton - Ingalls & Snyder

ATM machines?

Michael McNamara

Yes, even ATM machines. I think some of those things are just not going to run as high as a 7.8% margin business.

I think the other thing that you have to think about is that we invest a lot. You think about organic growth last year alone was a good $3 billion. We mentioned, this time it’s another $2 to $3 billion just in organic growth.

If we weren’t continuing to invest, and if we weren’t continuing to grow organically, and if all of a sudden we just stopped revenue growth and just decided to take what we have and make it work, I think you can get a little bit higher margin.

Part of what we’re doing is trying to absorb continually higher margins and at the same time grow and prepare for the future so that we survive the long term. I think Sanmina doesn’t quite have that characteristic.

Alexander Blanton - Ingalls & Snyder

They are not growing; that’s for sure.

Michael McNamara

Yes, so I think that takes some of the stress of margins down a little bit. We talked about even the design wins. We are getting a lot of design wins in computing. We are probably spending an extra $10 million just in R&D this last quarter, to prepare for the future.

$10 million is a lot of money to invest, but we think it’s going to pay off in multiple billions of dollars in the very near future. As you get into those investment modes and you ensure your survival and you continue to invest, I think it takes a little bit of pressure on margins.

But fundamentally, I agree with your assessment. We are still at 3.4% operating profit, up from 3.1% last year. But we actually do expect going forward to move up into 3.5 to 4%. That is partly a result of getting the original Solectron pieces working a lot better.

I think it’s coming. I think some of those cost challenges are putting a little bit of a pressure on us. I mentioned a 10 or 20 basis point hit just in this last quarter. I can also add onto that the fact that we had $10 million more R&D as a result of being successful, believe it or not.

I think those things put pressure on the business. But nonetheless, we will keep moving the ball forward. I think the most important point is I think you are fundamentally right. That business has an opportunity for higher gross margins. We are not fully realizing it. But I think that’s what’s going to give us our future to go drive into 3.5 and 4% margins.

Alexander Blanton - Ingalls & Snyder

Along the lines of what you mentioned about the growth and its cost, there was a report I saw today that you are planning to open a new plant in East China. The total investment there was listed as $300 million to produce computers, navigation, and medical equipment, as well as plastics, metals and other parts.

Could you comment on that? Is that the case? This was not a company announcement. It was a report from the Asian press.

Michael McNamara

I don’t know. East China is a big place.

Alexander Blanton - Ingalls & Snyder

Suzhou City.

Michael McNamara

Oh, Suzhou. $300 million, I don’t want to comment on, but for sure, we’re seeing significant demand on the notebook side, and we are going to have to significantly increase our capacity available to build notebook computers.

Once again, that’s a good example of how success actually breeds higher cost in the interim. What we’re trying to do is to build a growth plan, invest in the future, and absorb those investments in the future, yet continually increase our return on capital and increase our margins.

That’s what we’re doing; that’s where we are headed, and that’s what we’ll continue to see into the December and the March quarter. But this is a good example of what success gets you. All of a sudden you book a lot of business and you have to go get the plants ready to go absorb it.

Alexander Blanton - Ingalls & Snyder

Okay, thanks.

Operator

Our next question comes from Brian White - Collins Stewart.

Brian White - Collins Stewart

There have been a lot of stories about Hon Hai raising prices on some of the Taiwanese ODMs recently; I think 5 – 10%. If you can just talk a little bit about how that would impact your business; is that something you are thinking about? Are you seeing greater demand for the global footprint? Most of these companies are primarily focused in China.

Michael McNamara

I think these companies are under a little bit greater pressure. I think the 10 and 20 basis points might be light for a lot of those companies because they do have such a high percentage of business in China where the costs are going up even higher, and their lack of geographic diversification is probably going to hurt them a little bit now.

We view it has being a wonderful thing because as those business models come under significant challenge and they are forced to raise price, it sets a competitive bar in the marketplace that we can then participate in. So I think both near term and long term, those are positive events for us.

Additionally, as those costs go up, we are having the benefit as a result of the significant geographic diversification that we have and footprint that we have. Right now, this is going to be the first year in a long time where our Mexico operations and Latin American operations are going to grow faster than our operations in Asia.

Even Europe operations for the first time in many years are going to expand. That’s largely because of the redistribution of the supply chain that’s occurring as a result of the macroeconomic conditions and the significant price increases of labor in China.

So we view that as good and good. Good in the sense that if those guys go raise price, it takes some competitive pressures off us from a pricing standpoint. And two, it makes the worldwide geography a better opportunity for us to participate in because we have the broadest footprint worldwide.

Brian White - Collins Stewart

Okay, and just when we look at the September quarter, of your five markets, what markets do you think will grow?

Michael McNamara

Which markets will grow over which quarter?

Brian White - Collins Stewart

In the September quarter versus June, which markets do you think you are certain will grow in the September quarter?

Michael McNamara

We’re actually going to look that up a little bit.

Brian White - Collins Stewart

Typically, I think handsets go up. Consumer starts to go up. Your printer business goes up.

Michael McNamara

We are just looking up the data now. The biggest growth areas are going to be all the consumer businesses. So Mobile will have significant upside. Consumer Digital will have significant upside.

But we actually expect pretty good growth out of the whole bundle. The only thing I think that’s probably not going to see sequential growth is probably Infrastructure. But everything else will probably grow.

But I think the biggest growth drivers are probably going to be Consumer Digital. We actually think Consumer Digital so far is going to be the strongest growth driver for next quarter. I don’t believe; I know.

Brian White - Collins Stewart

Mobile’s only going up because of the new programs you are ramping.

Michael McNamara

Yes, new programs and it just always goes up that quarter. It always goes up.

Brian White - Collins Stewart

Even with the slowdown with your big customer, it would go up even without the programs?

Michael McNamara

Even if the big customer is flat, it would still go up.

Brian White - Collins Stewart

Okay.

Michael McNamara

That’s correct.

Brian White - Collins Stewart

Okay, thank you.

Michael McNamara

Let’s take one more question.

Operator

Our last question comes from Amit Daryanani - RBC Capital Markets.

Amit Daryanani - RBC Capital Markets

Thanks a lot; just a quick housekeeping question to start with. Interest expense seemed a little bit higher than what I was thinking. It was definitely up $8 million sequentially. Could you just talk about that and how should we think about it going forward?

Paul Read

You should just think about that as going forward roughly in the range of $40 to $45 million, and these dropped sequentially. We were into some short-term borrowings during the quarter, a little higher than the previous quarter. But again, we’re ramping in working capital requirements et cetera. So you should just think $40 to $45 million going forward.

Amit Daryanani - RBC Capital Markets

All right. And then just going back to the buyback question. I know the last time you did this and a few times after that, you had talked about how undervalued you perceive the stock to be, and this was the S&P 500 or the EMS group.

I’m just curious, given the fact we should generate $800 million of free cash flow this year and your net debt to EBITDA is around 1.2 – 1.3, what prevents you from doing an accelerated repurchase or a Dutch auction fairly soon, especially if you believe in the long-term fundamentals that you have outlined to investors for the last year?

Paul Read

We are restricted under Singapore law, Amit, for doing the accelerated stock purchase program. We have other methods available to us, but not that.

Amit Daryanani - RBC Capital Markets

Then what prevents you from using the other methods fairly soon?

Paul Read

Nothing.

Amit Daryanani - RBC Capital Markets

All right. Thank you.

Paul Read

All right, thanks very much.

Michael McNamara

Thanks very much for everybody’s participation and we look forward to talking to you all again.

Operator

Ladies and gentlemen, thank you for joining the call. This concludes today’s conference call. You may now disconnect. Thank you.

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Source: Flextronics International Ltd. F1Q09 (Qtr End 07/24/08) Earnings Call Transcript
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