Description

Overview

Since the end of 2012 FLEX stock has almost doubled, yet it still trades at less than 6x forward EBITDA and at an 11x P/E multiple. The company generates significant FCF and is growing net income by 5 – 10% per year. If you combine that with a strong commitment to buybacks, EPS should grow annually at 15+% for many years to come. A company growing EPS at a rate of 15+% per year and generating ROICs near 25% (and improving), while trading at an 11x P/E seems truly rare in this market. Upside is substantial as EPS growth will continue to compound and the multiple is very likely to expand as the business mix continues to improve.

Detailed Thesis

The story behind FLEX is one of transformation. The company is still in the early innings of the transformation and the stock price is still in the early innings of reflecting it.  

The historical business of FLEX and its EMS peers is mainly based on outsourced manufacturing (mainly assembly) for IT and telecom companies such as HP, Google, EMC, Cisco, etc. This business, which represents 57% of FLEX’s EBIT, is mature and highly competitive with lower margins. The transformation is a shift towards longer product life cycle, higher margin businesses in other industries such a Medical, Auto, Aerospace and Industrial. This trend is driven by the convergence of technology in other industries, including more complex and intelligent devices, along with continued pressure to improve margins. Until very recently companies in these other industries have mostly done manufacturing in-house, so outsourcing penetration rates are still less than 10%, suggesting a potential opportunity for many years to come.

While the margins for the traditional EMS business (i.e., the Consumer Technology Group - “CTG” and Integrated Network Solutions – “INS” segments) are targeted at a 2 – 4% EBIT range, the margins for the  growing non-traditional emerging businesses (i.e., the High Reliability Solutions – “HRS” and Industrial and Emerging Industries – “IEI” segments) have a target range of 4- 7%. The traditional businesses should have around flat revenue growth over time, while the higher-margin non-traditional businesses which represented 43% of FY15 EBIT should grow in double-digits.

If you listen to the calls of each publicly-traded EMS company, such as Jabil, Sanmina, Benchmark, Celestica, etc. they all pretty much say the same thing. So much so that if you don’t know which company you are listening to, it is hard to tell the difference from one company to another. They all talk about this same story, transitioning more of the business from traditional tech and telecom to the high-growth, higher-margins areas such as Medical and Auto. The thing is that no EMS company is better positioned than FLEX to take advantage of the long-term trend. FLEX has much more scale and in-house expertise than any of its competitors. The most immediate and largest growth opportunities are in Medical and Auto and FLEX dominates its peers in both. At its recent investor day FLEX indicated that its auto business is over 6x larger than its nearest competitor and has over 300 dedicated auto engineers to help customers. Our field research calls also suggest similar dominance in Medical.  

While competitors also talk about operating in Medical and Auto, most of what competitors due is “build-to-print” versus “sketch-to-scale” which FLEX can bring to the table due to significant in-house expertise. FLEX has over 2,500 engineers that no competitor can match. The engineers are needed for the “sketch” part as FLEX will help customers design the most appropriate product that can be manufactured at the least cost with the least risk. To get into the business requires building the in-house expertise and it is tough to hire a lot of expensive talent if you don’t have associated revenues yet. This is why competitors such as Celestica previously tried to enter the Medical business but ended up failing to become a significant player.

Another reason for higher barriers to entry in these high growth areas is due to regulation. For medical work, FLEX has 16 sites that are certified by the FDA. Similar government approvals are needed in areas like Aerospace. While FLEX doesn’t have similar dominance in Aerospace/Defense yet, Management expressed confidence that this will come over time and cited a 79% win rate at the Investor Day.

What is also great about these newer businesses is that they involve long-term contracts and provide significant visibility to help better predict future revenues. At its Investor Day, FLEX disclosed that for the HRS business (which is mainly Auto and Medical) that in FY16, FY17, and FY18 they have already booked 95%, 92% and 85% of projected revenues. This is substantial backlog that gives further confidence that FLEX will likely continue to exceed growth targets in this business.

For design work in areas such as Auto, FLEX is paid for the cost of design over time, rather than up-front.  Furthermore there is a long lead time between time to development and revenues. The point here is that FLEX has been investing in the business through the P&L and the benefits of future revenue growth and margins will continue to show more light in coming years.   

Even in the traditional areas such as tech and telecom, FLEX has been taking steps to separate itself from competitors. The first thing to point out is that FLEX has a major scale advantage over competitors. FLEX also has a VC business named Lab IX which invests in start-ups and helps them with development (so that when they are successful they will use FLEX for the manufacturing). FLEX has a significant presence in Silicon Valley and many other tech-oriented centers around the world that is not matched by competitors. The results of this can be seen as FLEX is the exclusive manufacturer for many high-flying growth-oriented hardware companies. Management will point out that it is the manufacturer for 8 of the last10 hardware IPOs such as FireEye, Nimble, Violin and Palo Alto Networks.  About $1B or over 10% of INS revenues comes from high-growth “converged” customers such as these, which should help offset weakness in the traditional INS business and could lead to relatively stable INS revenues over time which would be a win for the stock.

Valuation

Despite these clear advantages over competitors FLEX trades at around the same valuation or less than all of its peers outside of Sanmina. Competitor Plexus is the furthest along in the industry towards non- traditional business as over 60% of Plexus revenues are non-tech and they have industry leading margins and valuation. However, Plexus is a much smaller niche-focused company. Plexus doesn’t have true scale if a customer needs a global supply chain. Therefore, as Plexus’s customers grow larger over time, the customers will look to transition more towards a company like FLEX. Plexus is a good starting point to see how we should expect FLEX to trade as it continues to transition towards a better mix. Plexus trades at a forward multiple of 15x EPS vs. 11x for FLEX.

Even though FLEX has beaten consensus EPS for each of the last 8 quarters by an average of 14.0%, the Street is still bearish with 9 hold ratings vs. 5 buys. For FY16 we model EPS of $1.25 which exceeds consensus of $1.07. If you use a 13x multiple, then FLEX should trade at $16.25, which is over 30% above today’s price.

A hidden free option for FLEX is that it owns an 80% stake in Elementum which is being talked about as the Workday for the supply chain. We understand that about 6 months ago there was a Series B that valued Elementum at over $325M. If Elementum is truly the Workday for supply chain it could end up as a multi-billion asset for FLEX. Elementum could IPO at some point or Workday might seek to acquire it, which would be a windfall for FLEX. In addition, since Elementum is consolidated, every quarter there are over $10M of losses to accelerate growth for this early stage company that are part of the $200M of SG&A of FLEX.  

Risks

The biggest risk is that the larger traditional businesses continue to decline in revenue and offset the higher-growth areas, leading to continued pressure on top-line results. While this is possible, the risk of this already seems reflected in the stock and consensus estimates. Further, if these traditional businesses continue to decline, mix and overall profit are still likely to improve. To put this in perspective, if HRS and IEI grow by 10% this year (which could be conservative) and reach target margins, the INS and CTG businesses would have to have a collective revenue decline of 35% at target margins in order for EBIT to decline year over year. I use target margins rather than actual because IEI margins were below normalized levels last year because of over 150 new programs ramping which pressured the P&L. An annual decline of 35% for INS and CTG is highly unlikely and supports that even if they show revenue declines, overall EBIT is still likely to increase, and there is additional upside should INS and CTG revenues stabilize.

The CTG business, which represents 34% of revenue and 26% of EBIT, has an unclear growth profile. Management doesn’t even have a clear growth target for this business as lifecycles for consumer tech products tend to be short and there is not much future visibility, which makes it difficult to model. While this is the case, due to long-term investments previously made, FLEX could just as likely surprise to the upside here, particularly from a profit perspective. 

Management’ main goal for CTG is to achieve a better mix leading to target operating margins of a low 2-3%. Within CTG sits FLEX’s largest customer, Motorola. Motorola was acquired by Lenovo in October 2014 and there are fears that Lenovo will take all of the Motorola business in-house given that Lenovo has lot of extra capacity in China. FLEX does $1.0B of Motorola business in China which represents close to 4% of FLEX revenues. In addition, another $1.5B of Motorola business is in Brazil which represents about 6% of FLEX revenues. So there is worry about FLEX losing its largest customer, it reducing utilization/efficiencies, and the associated headline risk.

However, in reality this does not look like a big risk. This is because the Motorola business is at incredibly low margins and if FLEX loses the Chinese business it is estimated to have just a 2-3 cent negative impact on EPS. We heard that the only reason FLEX took the Motorola business in the first place is that FLEX was looking to build its relationship with Google. Now that Motorola is owned by Lenovo instead of Google, it has less strategic importance to FLEX. That said, Lenovo is also an important customer of FLEX, particularly outside of China in areas like Brazil, so there is no indication that Lenovo is going to take away the Motorola business. Further, if FLEX were to lose the Motorola business it would accelerate the mix shift towards higher margin and could lead to a higher multiple which would more than offset the negative EPS impact. Also, FLEX margins quickly recovered after terminating its relationship with RIM, so fears of losing the scale that comes with Motorola seem overblown.

There is also concern about the INS business, which represents 35% of revenue and 31% of EBIT. At the Investor Day, FLEX’s CEO commented that he thought that end markets for this business would decline by 5% annually and the company’s goal is to have stable revenues for this segment. Management called out record level bookings in INS that will start materializing in the 2^nd half of the year. This is possible but it is likely more of a show-me story as this segment has been down for the past 3 years.  This appears doable as this business includes high-growth higher margin customers such as FireEye which continue to represent a higher proportion of the mix. Plus even if this segment continues to decline, little capex investment is required - the segment acts as a “cash cow” to generate cash to invest in other areas and return capital to shareholders.

For the high-growth segments HRS and IEI, a worry is that margins come down over time. It is easy to look at the history of tech and communication products made by EMS companies and see that margins came down. So why won’t this also happen in non-tech? There are a number of number reasons including more upfront design work by FLEX and long-term contracts. However, from a long-term perspective the biggest factor which should support higher margins is that there is less standardization of products in non-tech/telecom industries.  For instance, think about cell phones…they used to come in all shapes and sizes, such as flip phones and with keyboards. However, today, most phones, whether they are made by Apple, Samsung or Microsoft, all pretty much look the same in terms of format. The design has been standardized which makes it easier for a customer to switch from one EMS company to another.

M&A is also a risk and historically has not worked out well unless it involves acquisitions of niche companies with specific skills. Customers prefer to have multiple suppliers where possible. So with a large M&A deal of a similar company there is great chance of losing customers, so 1+1 is less than 2. FLEX got burned when they acquired Solectron in 2007 and hasn’t made a large acquisition since. A large acquisition would also interrupt FLEX’s very active buyback program and could upset investors. Also, in the past, EMS companies grew their tech and telecom businesses largely by acquiring the manufacturing operations of customers, and then would transition those operations to lower-cost regions. This ultimately led to significant write-offs throughout the industry and burned a lot of investors. These types of acquisitions are less common today.

The good news is that since large acquisitions of competitors don’t generally work in this industry, no competitor combination is really a threat to FLEX’s scale and capabilities. Foxconn (aka Hon Hai) is considered the largest player in the space but they are more of a components manufacturer and are mainly limited to China vs. being a global player like FLEX.

Currency is less of a direct risk than one might think. About 90% of customer contracts are priced in USD. However, the risk, which is difficult to quantify,  is that since customer costs are in USD, in regions such as Europe, these customers might need to raise prices to end customers to offset the appreciation of the dollar. These higher prices could reduce demand and lead to smaller orders for contract manufacturing from FLEX and its peers. 

Catalyst

Continued execution towards transforming the business, exceeding estimates, and continuing the strong commitment to buyback stock. By doing this the stock doubled since 2012 and the upward momentum is likely to continue as people see FLEX separating itself more and more from the traditional business and its peers.