Flex: Deeply Discounted Industry Leader With A Potential Spinoff Catalyst

Summary

• EMS leader Flex’s exposure to high-growth markets should ensure a strong revenue outlook through 2025.
• With margins also moving higher on mix benefits and cost discipline, earnings should also ramp up in the coming years.
• At current levels, the stock has largely discounted the core business (ex-NEXTracker), so a spinoff could unlock significant value.

Thomas Barwick/DigitalVision via Getty Images

Flex Ltd. (NASDAQ:FLEX) is a leading electronics manufacturing services (EMS) company with one of the lowest-cost production footprints within the industry due to its presence in emerging markets. The core business is solid and should benefit from secular growth opportunities given its diversification into higher growth end markets.

Margin expansion is also a mid-term theme, as management's cost discipline should ensure ample operating leverage when conditions normalize post-COVID. FLEX's utility-scale solar tracking solution, NEXTracker, offers an additional upside lever over the long term - it operates in an oligopolistic tracker market and is set to grow in line with the broader utility solar power space.

Market conditions have led to a spinoff delay, however, allowing investors to buy core FLEX and NEXTracker at an attractive valuation. Using the recent $3bn valuation by private equity would imply a discounted valuation of ~5x fwd P/E for the core business - unwarranted, given the quality of the management team and the growth/margin profile of the key Reliability segment. A re-rating toward higher-value peers like Plexus at a mid-teens EBITDA multiple would imply a significant upside from here.

Leveraging Secular Growth in Key End Markets

As outlined at its investor day, FLEX has pinned its hopes on several high-growth markets, including next-generation automotive, cloud data centers, and digital healthcare. In total, these businesses currently contribute ~15% of revenue, although the projected 20% CAGR through 2025 implies an outsized contribution going forward.

For context, the next generation automotive end market factors in higher electric vehicle volumes and their richer technology content, as well as EV charging infrastructure, so FLEX is well-positioned to benefit from the secular EV shift. With auto connectivity over 5G to edge infrastructure also embedded, FLEX's expected 50% CAGR through 2025 signals its ambition here. In addition, the continued cloud data center expansion is also guided to drive a 14% CAGR through 2025, while digital healthcare solutions are expected to grow at a 14% CAGR as well. This leaves growth for the remaining Flex business at a steady ~7% CAGR through 2025 - at the upper end of the broader EMS industry growth rate (5%-7%/year).

Flex

Near and Mid-Term Guidance Move Higher

Heading into 2023, the company expects revenue to reach ~$27.8bn (+8.5% YoY) and deliver a high single-digit annual revenue CAGR through 2025. Unsurprisingly, much of the growth will be driven by high-growth verticals such as next-gen mobility, cloud, and healthcare (>20% annual growth), with its remaining businesses growing at a steady >7%/year. Operating margins are also guided to come in strongly at ~4.8% for 2023, driving overall EPS of ~$2.16/share.

Over the medium term, a >5% adjusted operating margin scenario seems well within reach given the combination of revenue growth, mix improvements, and efficiency gains (mainly from automation). Core FLEX (ex-NEXTracker) will drive ~$1.73 in EPS in 2023 and ramp up to $2.65 of non-GAAP EPS in 2025, implying strong bottom-line growth from NEXTracker as well.

While the overall EBIT margin outlook will come as no surprise given Flex's solid track record as well as the accretive mix shift toward auto and medical, the high single-digit revenue CAGR through 2025 was a particularly positive surprise. Plus, the mid-term guide does not account for capital allocation gains from buybacks and M&A, so there remains ample room for upside to the guide.

Flex

The NEXTracker Opportunity

Embedded within the FLEX portfolio is NEXTracker, the market leader in utility-scale solar tracking with a dominant IP moat (patent protection for the next decade). With over 50GW deployed in recent years, NEXTracker has also built a solid track record, ensuring a "sticky" customer base with high switching costs. The only real competition at NEXTracker's scale is ARRY, although, with backlogs on the rise, there's ample profit potential for both players. Unlike NEXTracker, ARRY went public in 2020, and since then, FLEX management has hinted at a potential spinoff down the line. Per management, NEXTracker achieved revenues of >$1bn and double-digit operating margins in 2020 (in line with peers), so extrapolating this based on the industry growth profile, NEXTracker should hit ~$1.2bn of 2021 revenues and ~$200m of EBITDA for 2021. Depending on how the company navigates semi shortages, there could be some volatility in 2022/2023, but I think the long-term earnings power is intact.

Valuation-wise, TPG's recent investment in NEXTracker converts offers a good indication - a ~$3bn valuation would imply a 2.5x revenue multiple or ~15x EV/EBITDA on 2021 numbers. While I think this could prove conservative given the timing (ARRY and FTCI multiples are well off their highs), ~$3bn for NEXTracker would imply a deeply discounted core FLEX (ex- NEXTracker). Assuming FLEX achieves its long-term financial model (high-single digits revenue and >5% EBIT by 2025), core FLEX is guided to hit EPS of $2.65/share. Further adjusting for the ~$3bn enterprise value for NEXTracker and assuming net debt declines to ~$1bn, core FLEX is on sale at an implied ~5x earnings at current levels.

	USD 'm
FLEX Enterprise Value (FY 2021)	10,286
Minus: NEXTracker Enterprise Value	3,000
Equals: Core FLEX Enterprise Value	7,286
Minus: Net Debt (Cash)	1,110
Equals: Core FLEX Market Cap	6,176
Divide: Diluted Shares Outstanding (FY 2025e)	430
Divide: Core FLEX FY 2025e EPS (in $)	2.65
Equals: Core FLEX FY 2025e P/E	5.4x

Click to enlarge

Source: Author, Company Financials, Market Data (27th April 2022)

Deeply Discounted Industry Leader with a Potential Spinoff Catalyst

Overall, FLEX offers investors a compelling "heads I win, tails I don't lose much" scenario - this is a combined business trading at a low to mid-single-digit EBITDA multiple despite incurring transitory COVID-19 costs. Plus, the overall business should grow revenue at a GDP plus rate for the years to come, with cost discipline and accretive M&A/buybacks also likely to boost the EPS growth algorithm for the mid to long term. Finally, we've yet to see NEXTracker's earnings power come through, but with solar recovering from its COVID lows, we could finally see management proceed with spinning off the asset.

Valuations are much different from when ARRY was listed, though, so I don't see NEXTracker commanding the multiples we saw in 2020. Still, NEXTracker's ~$3bn valuation at its last funding round is a start, so using that as an anchor implies a deeply discounted ex-NEXTracker multiple of ~5x mid-term earnings power. Relative to the growth/margin profile and FCF generation that core FLEX is capable of, I see ample room for the stock to re-rate.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.

Comments

[leonlai911]

Positive news out of FLEX:

seekingalpha.com/...

[hss87]

Fascinating interview from the CEO:

www.businesstoday.in/...

[mhargra34]

Great earnings:

seekingalpha.com/...

[Buysider2]

This article is accurate. I have followed Flex closely on both the sell side and the buy side since 1993, when it was transformed from a Singapore-based electronics components supplier to a San Jose, California-based electronics manufacturing services (EMS) company by Michael Marks, the first Chairman and CEO of Flex as it is now operating. The company remained legally a Singapore company, although all headquarters and other operations were moved in 1993 to San Jose.

When Marks took control in 1993, Flex was publicly traded, had roughly $100 million in annual sales, and was named Flextronics. The company grew very rapidly for the rest of the decade, when global electronic outsourcing was growing from approximately $10 billion a year in 1990 to $100 billion a year in 2000, or a compound annual growth rate of 25.9% a year.

Marks was a disciple of Richard Schonberger, who was one of the early “world class manufacturing” gurus who beginning in the late 1970’s, taught manufacturers in the U.S. how to manufacture more efficiently and with dramatically greater quality and dramatically less waste of time, money, materials, and labor cost. At that time, U.S. manufacturers were losing share to Japanese competitors who had adopted the advanced manufacturing and lower cost manufacturing practices developed at Toyota in the 1950s and 1960s. Then called “world class manufacturing,” those practices, included “continuous improvement,” “just-in-time inventory (supply chains),” “cell manufacturing,” “six-sigma quality,” “employee empowerment,” “flat organizations,” “pull-through assembly (kanban),” “go and see (gemba walks), and “kaizen events (brainstorming cost reduction and efficiency planning meetings).” That package of best practices is now commonly known as “Lean,” which connotes the lack of fat or waste in an organization.

Michael Marks introduced all those advanced manufacturing techniques to Flextronics in 1993 and Flex has been perfecting those practices ever since, in a non-stop process of continuous improvement for the past 29 years. At his first meeting with his managers in 1993, Marks gave everyone a copy of Richard Schonberger’s iconic 1986 book, “World Class Manufacturing, the Lessons of Simplicity Applied,” which book is still in print and can be purchased from Amazon for $19.00. Marks demanded his managers study and apply the lessons in the book, starting that day. In a nod to the employee empowerment he believed in, Marks also displayed a large loose-leaf binder that he announced was Flextronics’ “new policy manual.” Marks opened the binder, and it was filled with nothing but blank pages! During the next two years, Marks sent every manager in the company to one or more of Schonberger’s two-day, weekend, intensive, deep-dive world class manufacturing seminars, two of which I had attended myself a few years earlier. The minute I met Marks, I knew Flex would be successful, because I understood the manufacturing power of what Schonberger was teaching.

Flex grew both organically and by acquiring other EMS companies, including in October 2007, the second largest North American EMS company, Milpitas, California-based Solectron.

Solectron had originated the EMS business in 1977 and by assiduously adopting the best manufacturing practices that had been developed at Toyota by W. Edwards Deming in the 1950s, was able to populate circuit boards with components at about one quarter of the all-in costs experienced by the makers of work stations and personal computers. That meant computer and workstation OEMS like Hewlett Packard, IBM, and Sun Microsystems were able to cut costs by outsourcing the population of bare circuit boards to EMS companies like Solectron.

During the 1990s, Solectron and other EMS companies evolved from small companies populating circuit boards for electronic OEMS on a “consignment” basis, to companies who could eventually take on the complete design, procurement, circuit board assembly, complete product assembly, and even the packaging and delivery of the complete product to the ultimate user on a “turnkey” basis, which bypassed the so-called “OEMs,” many of which at that point had become research, design, branding, and marketing companies, rather than manufacturers. For example, by 2000, Solectron had a large plant near Milpitas, in which were located the entire manufacturing operations of several small networking, storage, and high-end electronics companies and several manufacturing divsions of larger OEMs as well, at least a dozen seperate manufacturing lines in total, including the entire manufacturing of Juniper Networks at that time, and the manufacturing of the largest division of Trimble Navigation. That was but one of many Solectron plants employing 70,000 people in 23 countries.

Along the way, Solectron invented one of the chief engines of outsourcing growth that fueled the ten-fold growth of electronic outsourcing during the 1990s, the plant purchase. In 1994, Solectron doubled its $400 million in sales by buying an IBM manufacturing plant in Bordeaux, France and contracting to manufacture for IBM all the products IBM had been making in that plant, which purchase added another $400 million to Solectron’s annual sales with the stroke of a pen. That was the first of hundreds of asset and plant purchases by EMS companies since 1994, primarily of OEM manufacturing assets in relatively high cost regions like the U.S., Canada, and Western Europe. Such asset purchases were numerous during the following ten years and then slowed as EMS companies began opening many of their own plants in low cost countries.

Sometimes, the OEM retains ownership of the plant, but contracts with an EMS company to operate the plant. For example, Flex makes Apple’s high-end MacBook Pro laptop in a plant in Austin, TX owned by Apple. Apple’s promotional material makes it seem that Apple is doing the manufacturing in the plant, but the manufacturing is actually done by Flex employees with machines and equipment developed by and owned by Flex! Flex is not mentioned in the Apple promotional videos and print material, at least none I’ve seen.

To raise money for expansion, Solectron went public in November 1989 at a then price of $6.00 a share. Five 2-for-1 splits later, the split-adjusted IPO price was reduced to $0.1875 a share. Because of rapid electronics outsourcing growth from 1990 to 2000, Solectron’s annual sales grew from about $130 million in FY August 1989 to more than $18 billion in Solectron’s peak sales year of its FY August 2001, a compound growth rate of almost 51% a year for 12 straight fiscal years, or roughly double the industry growth rate of almost 26% a year. Solectron’s sales topped out in FY 2001, primarily because of new competition from Foxconn of Taiwan and China, which company took most of the laptop and cell phone production that Solecton had counted on to fuel future growth, and by 2007 when it was acquired by Flex, Solecton’s annual sales had declined to about $12 billion a year. Solectron’s stock peaked on October 24, 2000, at an all-time intraday high of $52 5/8, an increase of 280.7 times in nearly 11 years, a compound annual growth rate of 66.9% a year. Because investors did not anticipate the huge growth of electronics outsourcing ahead, Solectron had gone public 11 years before at an IPO price that was a mere 9 times Solectron’s EPS for its prior August 1989 fiscal year.

At the end of 2000, at roughly 50 times Solectron’s expected EPS in its August 2001 fiscal year, Solectron’s shares were massively overvalued, as investors expected the huge growth rates of the prior 12 years to continue, which it did not. For a variety of reasons, the high growth rate of OEM outsourcing to North American EMS companies did not continue. During the decade that ended in 2000, the North American EMS companies had migrated a lot of their manufacturing skills to low-wage plants in China, Taiwan, Malaysia, and other Asian countries, and Chinese competitors like Foxconn acquired those skills and began taking huge shares of the fast growing cell phone, laptop, server and other low end outsourced business.

During the 2000-07 period, Solectron worked hard to replace the low end laptop and cell phone business it was losing to Foxconn with high-end, difficult-to-make networking, storage, router and switching products that were too difficult for Asian competitors like Foxconn and other Taiwanese electronics suppliers to make. By the time Flex bought Solectron in 2007, Solectron had become the most skilled electronics maker in the world. For example, at that time, Solectron was one of the four EMS companies that were making ALL of Cisco’s products. Solectron did about one-half of Cisco’s manufacturing, including all of the most difficult-to-make products, and Jabil Circuit, Celestica, and Foxconn did the rest. Foxconn made the lowest end, lowest margin Cisco products.

So when Flex bought Solectron in 2007, Flex acquired ALL of Solectron’s manufacturing expertise and also overnight became Cisco’s largest supplier. From that point on, Flex has reigned as the globe’s most skilled and lowest cost electronics manufacturer and the second largest EMS company in the world, next to Foxconn.

[DamienDuJ]

@Buysider2 Very welcome background on this company. Thanks for the education. What do you think of the new CEO? Personally, I feel Flex is in the best hands it's ever been...

[Buysider2]

@DamienDuJ Thanks! I think Revathi is doing a super job. She has focused Flex on the things it does best and on Flex’s higher margin, faster growing markets. Her management and supply chain experience in the electronics division of Eaton prepared her well for this job. The key to assessing Flex’s future is to recognize that its fastest growing businesses are also its most profitable businesses. That is the surest way to achieve continuously increasing sales and margins!

[katieliu76]

@Buysider2 I agree completely. Notice how Flex has been spared punishment while the rest of the tech sector burns. Sadly, there may not be an IPO this year the way valuations are crashing...

[Almagro9]

Any word on when Flex will proceed with the spin? They have delayed this for too damn long!

[Geraldo9]

@Almagro9 The way the Fed is going, there will be no IPOs this year, my friend...

[katieliu76]

Flex is a different beast under Revathi. Don't forget the ESG crowd. They will soon come rushing in when the solar biz gets spun out...

[sidnal5]

Interesting.Thanks.