Flex Ltd: Oversold

Summary

• For the last 12 years, CEO Mike McNamara has shifted Flex's business focus towards the higher margin operations of design, engineering and supply chain services (management's "sketch to scale" initiative).
• The announcement of an investigation by Flex's Audit Committee into improper accounting practices in the past has caused a 21% crash in Flex Ltd's stock price.
• Over the next 3 years, expansion in the higher margin "sketch to scale" business will dramatically boost revenues, providing an attractive opportunity to investors as the stock is currently severely undervalued.

The Crash

Flex Ltd's stock (NASDAQ:FLEX) was smashed before its Q4 results were due to be released due to an earnings downgrade by management, and the claims by a former employee of improper accounting practices within the company:

In addition, as mentioned in our press release, in accordance with our high standard corporate governance, the Audit Committee of our Board of Directors with the assistance of independent outside counsel is undertaking an independent investigation of allegations made by an employee, including that the company improperly accounted for obligations in a customer contract and certain related reserves.
(Source: Seeking Alpha - (FLEX) Q4 2018 Results - Earnings Call Transcript)

This caused the stock to fall over 21%:

(Source: Google Finance)

This has reduced Flex's valuation to a PE ratio of 13 (TTM), despite the growth story that is still unfolding at the company. As such, investors must decide if they believe the revelations from this investigation (and potential historical earnings revisions) will cause material harm to the company moving forward. Class action lawsuits by Flex shareholders represent the primary future risk to Flex, however, I do not anticipate any realistic outcome from this situation to present material risk to the future of Flex, and as such, the recent falls represent an opportunity for interested investors to enter positions (however, all investors should perform their own due diligence and understand the risks to shareholders that exist in these situations).

Growth

Flex Ltd is a multinational manufacturing corporation, and since 2006 Flex's management has shifted the company's focus towards the higher margin businesses of providing design, engineering, and supply chain services and solutions to worldwide OEM's. This strategy has experienced early success in the form of increased margins, and when combined with the growing strength in the US manufacturing sector, revenues will be dramatically increased by 2020:

FLEX data by YCharts

(Source: Trading Economics USA Data)

The level of interest for our Sketch-to-Scale solutions remains very high and are a huge differentiator. This was evident at CES in Las Vegas this year where all four of our business groups were well represented and we had record customer interest in our Sketch-to-Scale solutions offering. The pace of change and disruption is intense but we are finding numerous ways to partner with customers and enable their innovation by leveraging our deep vertical focus and expertise into adjacent or complementary industries with success. For example, recent autonomous vehicle program wins by HRS leveraged CEC's complex engineering knowledge of the data center which is becoming integrated in the car. Combining that key CEC skill set with HRS experience for automotive-grade manufacturing and supply chain solutions creates significant marketplace differentiation.
(Source: Michael McNamara, CEO Flex Ltd. Q318 Earnings Call Transcript)

Management has provided strong forward guidance as a result of the forecasted success of its "sketch to scale" program, providing guidance of 2020 EPS > $1.80 (an increase of over 75% based on the current TTM EPS of 1.01):

Steven Milunovich (UBS)- You've talked a little bit about strong growth in fiscal 2019. I think you've reviewed with the board your three-year outlook. Do you still believe you can do the $1.80 in fiscal 2020? And given that you're a little behind this year due to the Nike investment, does that take away that potential upside to $2-plus that you talked about at the Analyst Day?

Michael McNamara (Flex CEO)- I don't want to spend really time talking about 2020 or even 2019 in any kind of details. We've laid out a plan at Investor Day, last Investor Day, which was the same plan we laid out a year earlier. We have a number of initiatives that we're driving to get to those plans. 2019 is going to be the beginning of that rise as we head towards our 2020 plan, and those targets are still the ones that we're driving to at this point.
So, I think the most important thing is we stay focused at delivering, finishing up this year, finish off our investment year and really pivoting our company into really being a growth year for earnings, revenue and operating profit which we expect in 2019. So, I think you're going to start to see the beginning of that build right from the bat as we start in Q1 and – but I don't want to give – affirm that that's the number we're going to hit. It's just that those are the targets that we remain very, very focused on.

Even taking management's guidance figures with a grain of salt, (and considering the stock's conservative PE ratio of 13), an increase in EPS of anywhere near this magnitude would boost Flex's stock price more than 70% (timeframe of 2-3 years).

Q318 Earnings

Flex Ltd's third quarter results were broadly in line with all key financial metrics that management provided back in October 2017, reflecting management's commitments to its goals, the companies' continued growth, structural portfolio evolution and returning capital to shareholders (via share buybacks). Quarterly sales were approximately $6.8 billion, up 10% y/y and above management's guidance range. All four of Flex's business groups met or exceeded their respective sales guidance ranges.

Our quarterly operating income came in at $220 million, which is modestly lower than the prior year and almost entirely attributed to the increased levels of investment required for our new businesses and to support our Sketch-to-Scale vision. Our adjusted operating margin was 3.3%, which was up nearly 30 basis points sequentially, as we benefit from our strengthening top line and begin to move away from our heavier investment year profile. Return on invested capital was 17%, remaining well above our cost of capital and reflecting our elevated levels of investment which have pressured our profitability as we continue to position our company for future growth.
(Source:Christopher Collier, CFO Flex Ltd. Q318 Earnings Call)

(Source: Flex Q318 Presentation)

Flex's CEC business (Communications & Enterprise Computing) returned to management's targeted adjusted operating margin range at 2.5%, generating $50 million in adjusted operating profit.

We continued to transform our CEC customer portfolio and expand our cloud data center capabilities with targeted investments in engineering and reference platforms. These elevated costs, coupled with lower overhead absorption due to lower CEC revenue levels, has pressured profitability year-over-year.
(Source: Flex Ltd Q318 Earnings Slides)

The CTG segment (consumer technologies, wearables, gaming, mobile etc) generated $39 million in adjusted operating profit, achieving an adjusted operating margin of 1.9%, (slightly below the targeted range of 2% to 4%). This represents growth of over 26% q/q. Growth was impacted by the transition of the Nike manufacturing facility, with increased efficiency derived from this transition expected to appear in fourth quarter results.

IEI (Industrial & Emerging, Industries, Semiconductor & Capital Equipment etc) achieved an operating profit of $61 million and a 4.1% adjusted operating margin (inside management's targeted band of 4% to 6%). The IEI segment is successfully transitioning larger clients to the higher margin "Sketch-to-Scale" program.

We expect to sustain this strong growth trend as IEI capitalizes on its strong design and innovation position in a rapidly digitizing industrial market.
(Source: Flex Ltd Q318 Earnings Slides)

HRS (High Reliability Solutions) consists of both Medical businesses (including Consumer Health, Digital Health, Disposables, Drug Delivery, Diagnostics, Life sciences & imaging equipment) and automotive businesses (vehicle electronics, connectivity and "clean" technologies). HRS businesses generated $101 million in profit, reaching operating margins of 8.2% (exceeding management's target), while continuing to actively invest in expanding its design and engineering capabilities with the goal of reinventing itself as a design and manufacturing partner for OEM clients.

The Chart

The stock has been in a strong downtrend since January, with bears still strongly in control as both the 100 and 200 day week MA have offered no support. Due to the dramatic price falls since the Q4 earnings, I would not recommend waiting on the sidelines for too long as the downward gap is vulnerable to being filled:

(Source: TradingView Charts/My own TA)

The 61.8% retracement level of the multi-year uptrend provides a strong support level for price to stabilize while limiting downside risk.

Financial/Capital Management

For several years management has been buying back shares with excess capital, a trend that will continue into the future:

San Jose, CA, August 18, 2017 –Flex today announced that on August 15, 2017, it received shareholder approval to purchase up to 20% of its outstanding shares. Since the beginning of fiscal 2012 through the first quarter ended June 30, 2017, the Company repurchased approximately 298.8 million shares for approximately $2.6 billion and retired all of these shares.
(Source: Flex IR)

FLEX data by YCharts

As such, despite not paying out a dividend distribution to shareholders, management still effectively utilizes excess capital to the benefit of shareholders. This excess capital could also be utilized to cover any liabilities arising from the investigation/class-action law suits.

(Source: Yahoo Finance)

Flex maintains a healthy balance sheet, with low debt despite expanding operations, and cash levels remaining stable despite the strong share buyback program.

Conclusion

The recent falls in the Flex Ltd share price presents an opportunity for investors to enter a position as the company shifts its focus towards higher margin business segments, with management providing strong forward guidance for 2020. The continuing success of this shift combined with the continued strength in leading indicators for the US manufacturing sector suggests a strong investment case for potential Flex investors.

Of course, this thesis is on the proviso that the revelations from this investigation into historical accounting practices (and potential historical earnings revisions) will not cause material harm to the company moving forward. Class action lawsuits by Flex shareholders represent the primary future risk to Flex, however, I do not anticipate any realistic outcome from this situation to present material risk to the future of the company or its growth story. However, all investors should perform their own due diligence and understand the risks to shareholders that exist in these situations.

Analyst’s Disclosure: I am/we are long FLEX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.