Description

FLEX has been written up several times in the past, most recently in May 2021.  I won’t rehash too much of the detail covered in that note, instead I’ll instead focus on what has transpired in the last two years and why we believe this is a highly actionable long at today’s prices.

To summarize, FLEX has been undergoing a quality transition as it walks away from slower-growth, lower-margin legacy end-markets and focuses its resources on categories with open-ended growth opportunities, favorable contract terms, and better margins.  While the benefits of this transition have shown through in FLEX’s revenue growth over the last year, transitory issues related to pandemic-induced supply chain shortages had an adverse impact on operating margins, particularly in FLEX’s more attractive Reliability segment, and free cash flow has been depressed by extraordinary growth in inventory.  These issues are now beginning to abate and we believe FLEX is poised to return to margin expansion and see outsized growth in FCF over the next few quarters.  Further, with the recent IPO of NEXTracker (“NXT”) and the anticipation that it will be fully spun-out later this year or early next year, FLEX is poised to repurchase as much as 20% of its stock over the coming year, which should help to close the considerable discount at which Core Flex trades relative to its EMS peers.

FLEX is one of the world’s largest electronics manufacturing services (“EMS”) companies, offering outsourced engineering & design, manufacturing, and supply chain services to customers across 100 facilities in 30 countries (45% Asia / 35% Americas / 20% Europe).  FLEX typically provides its services under two economic models:  1) Fixed Prices, in which the customer pays FLEX a set amount for the finished product, inclusive of component costs and margins; or 2) Open Book, in which component costs are treated as a pass-through and FLEX is paid a fee reflecting just the services it provides.  The company reports revenue and operating income according to three segments (see exhibit 4 for more detail): 

• Agility (51% of revenue / 45% of segment income):  includes high volume, short life-cycle products, including consumer electronics; consumer appliances; and data center, communications, and enterprise networking equipment.  Over the last 5 years, mgmt. has made a concerted effort to walk away from lower-margin consumer electronics business and focus resources on higher margin, longer life cycle products.  As this has happened, operating margins have grown from 2.6% in FY20 to 4.4% in FY23 (ended 3/31/23).
  
  

• Reliability (43% of revenue / 40% of segment income):  includes longer life-cycle products such as automotive systems, medical products, industrial equipment, and renewable energy.  Operating margins today are 5%, below pre-COVID levels of >6% given 1) lingering supply chain constraints leading to underutilization of certain facilities and 2) ramp costs related to new programs.
  
  

• NEXTracker (7% of revenue / 16% of segment income):  NEXTracker is distinct from FLEX’s other businesses in that it is an OEM rather than contract manufacturer (hence one reason for the spin-off.  NexTracker makes solar tracking systems used to enable utility-scale solar arrays to track the movement of the sun throughout the day, ensuring maximum energy efficiency.  On Feb. 8th, 2023, FLEX completed an IPO of 21% of NXT shares, leaving it with a 61% interest in the business (TPG owns the other 17%).  In June, FLEX sold down another 10%, taking its interest down to 51%.  Management has indicated they intend to pursue a tax-free spin of the remaining stake in the business and the company disclosed on June 28th that they had requested a private ruling letter from the IRS regarding the tax-free nature of the potential transaction.  As of now, FLEX continues to consolidate NexTracker in its financials, which we believe contributes to the misvaluation of the stock.

Thesis

• End-market mix shift will drive accelerating revenue growth and margin expansion.  Since taking over as CEO four years ago, Revathi Advaithi has made a concerted effort to walk away from low-margin, fast-turn business and prioritize longer duration programs where FLEX can add more value, has greater visibility, and can earn better margins.  The chart below illustrates the magnitude of this shift in just a few short years.  In FY20, Consumer Devices accounted for 15% of revenue; today they are half that.  Reliability revenue (orange) today accounts for 45% of Core Revenue (excludes NEXTracker), up from 39% when Advaithi took over.  With Reliability revenue poised to grow low-double digits this year and Agility down MSD to LDD, Reliability will account for approximately half of Core revenue by the end of the current fiscal year.  This matters for two reasons:  1) As the fast-growing lines of business become larger, they will continue to put upward pressure on consolidated revenue growth; and 2) Reliability has historically garnered better margins than Agility.  Though recent figures are muddied by supply chain constraints and investments made to ramp new programs, if we look prior to the pandemic, Reliability margins of >6% were well above Agility's 2.6% margins.  Management has managed to improve Agility margins to north of 4%, but Reliability margins could easily expand to above 6% when supply chain issues are fully resolved. 

• Moderating competitive intensity / industry-wide tailwinds.  The history of the EMS space dates to the 1960s but in many ways the heyday of the industry was the 1990s when the PC revolution spurred a generational increase in demand for consumer electronics.  With seemingly endless demand for new products produced at scale, Flex and its rivals built out manufacturing facilities across the globe.  In time, many of the formerly nascent new product categories began to mature and competition for business amongst EMS players intensified as Chinese and Taiwanese competitors such as Foxconn (Hon Hai) gained scale by leveraging local low-cost labor.  Following the burst of the dotcom bubble, the proliferation of smart phones, tablets, flat panel televisions, and related products were the primary driving force within the industry.  But for the last half dozen years, a meaningful change has taken place, led first by Jabil and now carried on by Flex.  Rather than continuing to subject themselves to annual feast-or-famine life cycle of the next iPhone iPhone or Samsung Galaxy, Jabil and Flex have increasingly pursued business in categories that are 1) outsourcing to the EMS world for the first time, providing a multi-year growth opportunity; 2) have strong secular growth trends; 3) have longer product life cycles and more reliable demand forecasts; and 4) require specific technical expertise, regulatory approval, or other features that limit competition.  This shift in focus has enabled them to increasingly play in their own sandbox, away from the ultra-competitive end of the market that has come to be dominated by Foxconn.  And because a number of new categories exist for which Flex and Jabil are uniquely well positioned to tackle, both are now in the position of being able to choose their customers to suit their strategic goals, providing a tailwind to both revenue growth and margin expansion.  As one contact stated, “this is a golden age for EMS,” yet the market continues to value FLEX in much the way it has for the last decade.
  
  

  • "The industry itself is growing.  It isn't just FLEX taking share.  The size of the pie is increasing and everyone has more opportunities for revenue as a result.  This is true of lots of domains - healthcare, cloud computing, consumer products, etc… For incumbents in EMS, this is a golden period.  They are on a vertical growth path.  The market is accelerating."  - Former FLEX employee
    
    

  • "That's absolutely correct [that Jabil, Flex, and others are increasingly competing in a more rational way than a decade ago].  It wasn't until 2019 that Jabil changed their whole compensation structure to be focused on margin and cash flows.  Flex quickly followed.  You aren't seeing any bad actors spoiling pricing.  If you don't grow revenue but do grow margin and FCF, shareholders are fine with it…They are ready at any given time to say no to an offer.  The market is 10x better than it used to be" - Jabil IR
    
    

  • "They have been working at this a long time, and their businesses are getting better.  They have put in place the processes, people, and management to incentivize higher quality business.  For sure there are cycles, but they have proved to be resilient and profitable through those cycles…There are several filters that determine who is the best match between the customer and EMS - capability, footprint, certifications, margin, revenue size.  FLEX and JBL have been getting much more selective in the customers they are taking on to make sure it is a good fit."  - Former Sr. Director of Global Account Management at Flex
    
    

• NXT growth will reaccelerate.  While an investor interested in owning Core Flex could simply hedge out the NXT exposure, we have elected not to.  It is beyond the intended scope of this write-up to address all of the issues at play in the utility-scale solar space, we are generally bullish on the opportunity set facing the industry and believe NXT is well positioned to maintain its market share as Inflation Reduction Act tax credits drive a significant wave of capital investment over the coming years.
  
  

• Outsized FCF growth.  FLEX management has guided to an 80% FCF conversion rate over the long-term.  However, for the last two years the company has been forced to stock excess levels of inventory in response to supply chain disruptions.  Net of customer advances, this has reduced FCF by approximately $1bn on a base of $927m.  But just as the building of inventory pressured FCF, as it is released, FCF should benefit.  As it is, the $600m of guided FCF for 2024 only represents 60% of Net Income guidance for the year (50% if we compare to Adj. Net Income).  Nevertheless, the $600m would represent a 5% yield.  If FLEX is able to achieve its target 80% FCF conversion ratio on current guidance (nevermind that we are materially above guidance!), shares would be trading at a 7.5% yield, with the added benefit of a “special dividend” to come from inventory destocking.
  
  

• Share Repurchase Opportunity.  Management has stated their #1 capital allocation preference right now is for share repurchases.  They were unable to buy a significant amount last year given the impending NXT IPO.  Ultimately, they repurchased $337m.  With at least $600m of FCF being produced over the next year, along with any additional inventory bleed-down and NXT share sales, FLEX could generate more than $850m of incremental capital for repurchases this year alone.  Beyond that, FLEX is sitting on $1.2bn of proceeds from prior NXT share sales.  Excluding that it has less than 1x leverage.  Should management choose to, they could modestly increase their leverage and buy another turn or so of the equity. We don’t think it’s unreasonable to think mgmt buys back $1.8bn of stock in the next 6 quarters, or 20% of Core market cap.
  
  

• 2024 Guidance is too conservative.  Excluding NXT, FLEX has guided to revenue growth this year of 1% and flat operating margins.  This compares to JBL’s guidance of core revenue growth of 8% - 10% and 20bps of margin expansion (We strip out the sale of their mobility business and a shift to a consignment model in their cloud business).  While FLEX and JBL’s end markets don’t perfectly overlap, there is a considerable amount of commonality.  In each of the last two years, their growth has been within 1% to 3% of each other (with FLEX putting up the better growth in each year).  Further, last year, FLEX initially guided to 8% revenue growth and ultimately clocked 16%.  The prior year, management guided to to 5.7% and came in at 8%.  The point is, management has a history of guiding conservatively and their close peer is underwriting 7% - 9% more growth this year.

Valuation

We value FLEX on its Core earnings (FLEX excluding NXT) and add to it the current market value of FLEX’s stake in NXT, net of assumed tax leakage.  We think Core FLEX can do $2.77 of earnings in FY25 (3/31/25).  Capitalizing it at 10x yields a value for Core FLEX of $28.  NXT adds another $7.23 per share of value ($4.84 for the remaining shares and $2.40 for cash proceeds from shares already sold) , for a target price of ~$35.00, 30% above today’s priceWe view the 10x multiple as quite defensible both relative to FLEX’s historical valuation and those of its peers.  Today, JBL trades at 13x and other peers trade for 10x+.  Viewed differently, at current market values, FLEX’s interest in NXT is worth $2.5bn, or 19% of FLEX’s current market cap.  Aggregate proceeds from the two sales, which largely still sit on the balance sheet, amounted to $1.2bn.  Backing out FLEX’s interest in NXT and the related cash yields a market value for Core Flex of just $8.3bn, or less than 8x next year’s earnings, far too cheap for a business that benefits from many of the same trends as its more richly valued peers.

Risks

• Economic Sensitivity.  While FLEX has made great strides in shifting its businesses to more predictable end markets, it is still subject to cyclicality, in both its legacy consumer electronics business and its new growth areas.  We think the secular growth in areas such as renewables and electric vehicles should provide some ballast against an economic downturn, FLEX would not be immune.
  
  

• Today’s thriving categories will ultimately become commoditized.  As has been the case since the dawn of the EMS industry, today’s growth end-markets will ultimately mature, and the technological expertise needed to manufacture for them will eventually become commoditized.  That is the natural cyclicality of this industry.  However, given the number of new growth categories, and the fact that many of them are in their nascency, we think FLEX has at least a decade of favorable industry tailwind behind it.

Catalyst

The impending tax-free spin-off of NXT and the related repurchase of ~20% of the float.