Description

Thesis:

Flex is a buy because it is too cheap.  It trades at roughly 8x its earnings power.  The company offers a strong value proposition to customers and is well positioned to grow at attractive incremental returns. 

Why is it cheap?

Flex’s stock has suffered from a 1-2 punch of bad news.  Last October, Flex declined sharply when it disclosed the termination of its high-profile relationship with Nike and the departure of its long-time CEO.  More recently, Flex has been dragged down by the escalation of trade rhetoric between the U.S. and China.

Company description:

Flex is a contract manufacturing firm specializing in electronics.  The company offers a variety of supply chain solutions and services.  Flex operates over 100 facilities in 35 countries staffed by ~200,000 employees.  The company has over 50mm sf of manufacturing capacity.  Flex does not have a 10% customer.  The top 10 customers make up 43% of revenue. 

Flex has 12 industry verticals with over $1b in revenue.  These areas include consumer electronics, enterprise computing, telecom equipment, industrial, automotive, healthcare, home appliances, lighting, and capital equipment. 

Value proposition to customers:

For most OEMs, it makes a lot of sense to outsource production of electronic components to an EMS company such as Flex.  Flex offers lower production costs due to manufacturing expertise, global scale in procurement, and superior inventory management.  OEMs also benefit from a faster time-to-market, reduced capital investment, lower ongoing fixed costs, and access to design, engineering, logistics, and other supply chain services. 

Well positioned for growth:

Increasing electronics content is a secular trend that is benefiting demand for EMS services in most industries and geographies.  In addition, there is an increasing trend towards outsourcing.  EMS penetration of this growing TAM has increased from <25% in ’10 to 31% in ’18.  

Flex’s scale and multi-industry expertise provides an advantage when bidding against competitors.  In addition, Flex’s portfolio shift has passed the inflection point where growing areas are large enough to overcome shrinking business lines (on-premise corporate data center, 4G telecom). 

Flex’s auto business is a great example of how the company is capturing the increased demand for electrification and connectivity.  In ’12, Flex was on ~100 nameplates with $43 in content per vehicle.  In ’18, Flex was on ~460 nameplates with $137 content per vehicle.  In ’20, Flex will be on ~550 nameplates with $185 content per vehicle.

Background on Nike relationship:

-          10/15: Flex announced it had entered into a partnership with Nike to “reinvent” its shoe manufacturing supply chain.

-          5/16: Investor day highlighting Nike contract win as core part of transformation initiative.

-          10/17: Flex opened a new factory purpose built for automated shoe manufacturing.  Breakeven was expected by 3/31/18.

-          4/18: Flex reduced medium term outlook on continued Nike losses.  Nike contract breakeven target pushed to 2H FY’19. 

-          5/18: Investor day featuring COO of Nike reassuring Flex investors

-          10/18: Nike terminates relationship. 

My take:  Flex’s sell-off was a massive overreaction.  At its peak Nike was ~1% of revenue, different from the rest of the business, lost money, and was a significant distraction.  The CEO that led the initiative is gone so this is no longer an issue of significance. 

Thoughts on new CEO: 

Revathi Advaithi was hired in February from Eaton where she was the COO of the electrical segment.  Her messaging so far has focused on improving operational execution and free cash flow.  This is a welcome change as the prior CEO had too many pet projects and growth initiatives. 

On a recent lender call, the CFO indicated that Revathi is not looking to do any major M&A or make any significant strategic shifts.  In addition, on the previous quarterly call, he reiterated that Flex will continue to return 50%+ of FCF to shareholders. 

Valuation:

Over the past decade, Flex has averaged returns on tangible capital in the low-teens.  Given the current strategy (back to the basics), I think it is reasonable to expect (macro aside) that the company will grow at similar returns. 

The company is not overearning, the balance sheet is investment grade, and management is shareholder friendly.  Therefore, ~8x economic earnings power of ~$1.15 (I include SBC as an expense and make a few other minor adjustments) seems way too cheap.  10-12x seems much more reasonable.  The company also has a portfolio of venture investments that is currently held at cost on the balance sheet at $.55/shr.  The biggest investment is in a supply chain software company called Elementum, which seems like it has potential and could be worth quite a bit more than book value. 

If we take $1.15 of EPS x 11.5x P/E + .55 of non-operating assets = $13.78/shr. 

Therefore, I think a more reasonable price for FLEX is $13-14/shr, 40-50% higher than the current price. 

Key risks:

There are two key risks to owning this stock.  The first is a further escalation of the U.S./China trade dispute.  Flex is the epitome of a company that benefits from global trade so any disruption to the current world order is likely a net negative.  ~25% of Flex’s revenue is from products produced in China.  The portion of that revenue that is sold to the U.S. could be at risk of disruption.  Since Flex is the largest EMS company in every key non-China manufacturing region (and has excess capacity) the company is very likely to retain the business if the customer wants to move manufacturing regions to avoid tariffs.  Even so, this would likely lead to underutilized/stranded assets in China. 

The second key risk to owning this stock is an economic slowdown.  Demand for electronic components is cyclical.  In FY’10 (ended 3/31/10), revenue declined by 22%.  As a mitigant, in a downturn Flex generates a ton of FCF (working capital liquidation) so the company is not prone to financial distress. 

Catalyst

cash flow