Description

Flex Inc. (“FLEX”) is in the midst of a multi-year transformation towards becoming a higher-quality, higher-growth entity serving more stable customers in a more meaningful way. At only 9.2x cons. FY20 P/E (Note: March year-end), investors today are being given a very attractive entry point to invest in this transformation due to short-term issues which will abate over the next 12 months. My base case is a low-20s stock in 12 months (50% upside) although there is a very achievable bull case that would put this in the high-20s for ~100% upside from these levels.

For the remainder of the write-up, I’ll give a high-level overview of the business, discuss the transformation underway, discuss the short-term issues that are yielding an entry point, discuss some optionality from JVs and then get into the valuation.

Business Description:

FLEX is an outsourced manufacturer for a wide variety of companies in the technology, consumer, industrial, and healthcare industries (as well as others). They are classified as an electronics manufacturing services (“EMS”) company, although that is a bit of a misnomer given the breadth of services they can offer as well as the breadth of customers they currently serve. Historically, the EMS industry has had a negative stigma associated with it (not undeserved). If you go back 5-10 years, this business was driven in large part by labor arbitrage and consisted mainly of commoditized assembly of communications products, PCs and hardware. There are still Asian competitors who compete on this basis (Hon Hai a.k.a. Foxconn being the largest) but FLEX has transitioned away from this business over time, and increasingly provides services that touch the entire value chain across a broader set of customers. In the last 5 years, EBIT from the more-commoditized tech/consumer business has declined from 50% of the total to 33%, with the incremental EBIT going into higher-margin differentiated businesses like medical products and auto electronics. They have become a lot more strategic to their customers, and in some cases are the single-source provider for all of their manufacturing capabilities (e.g. Fitbit, most Bose products). In these situations, FLEX’s revenue line is essentially their customers’ COGS line. In other situations they collaborate and engage with their customers to design new products – they call this “sketch-to-scale” (i.e. from the drawing board/design “sketch” to full manufacturing capabilities “scale”). Sketch-to-scale revenue has gone from only 7% of total revenues in FY13 to 27% in FY18, and it is expected to grow to 40% in the next 2 years.

FLEX reports in four segments. I’ll go through these in rough order of most to least attractive:

1.    High Reliability Solutions (“HRS”) – 19% of sales; 42% of EBIT

• Consists of products that are more highly-engineered, particularly in medical products, automotive electrification/connectivity, and defense & aerospace
• Highest portion of “sketch-to-scale” revenues and deeper customer relationships
• 8.0% LTM EBIT margins vs. 6-9% LT target
• 10% LT revenue growth target
• Key customers include Abbott, Johnson & Johnson, Ford, Nexteer

2.    Industrial and Emerging Industries (“IEI”) – 24% of sales; 26% of EBIT

• Industrial products including energy & metering, semiconductor tools & equipment, office solutions, industrial automation, lighting
• 3.9% LTM EBIT margins vs. 4-6% LT target
• 10% LT revenue growth target
• Key customers include Teradyne, Applied Materials, Xerox

3.    Consumer Technologies Group (“CTG”) – 27% of sales; 12% of EBIT

• Consumer-related products in connected living, wearables, gaming, VR, PCs, tablets, printers
• Increasingly expanding to include non-electronic products (e.g. Nike relationship)
• 1.6% LTM EBIT margin vs. 2-4% LT target (note: depressed due to Nike ramp-up, to be discussed later)
• 5% LT revenue growth target
• Key customers include Motorola Lenovo, Nike, Bose

4.    Communications & Enterprise Compute (“CEC”) – 30% of sales; 20% of EBIT

• Telecom, networking, server & storage products
• 2.4% LTM EBIT margin vs. 2.5-3.5% LT target
• >0% LT revenue growth target
• Key customers include Cisco, Nokia, Huawei

FLEX’s Business Transformation:

As mentioned above, FLEX is in the process of transforming from a legacy EMS company to a higher-quality, higher-growth entity serving more stable customers in a more meaningful way. A helpful way to conceptualize the magnitude of this shift is to compare the characteristics of the legacy business (largely their CEC & CTG segments ex-Nike) to their to their newer business lines (largely the IEI/HRS & Nike businesses).

The key takeaway here is that in the process of shifting from a legacy EMS to newer business lines, FLEX is becoming higher quality in a lot of ways. The business becomes higher margin as they deepen their relationships with customers and avoid low-value activities with limited competitive differentiation and frequent bidding cycles. The business becomes higher growth as they shift towards industries where a large portion of manufacturing is still done in-house and where products are increasing in complexity and electronic/mixed content, requiring capabilities that their customers often do not have. Finally, the business becomes more stable as the customer base diversifies and as they produce products with longer lifecycles and greater certainty of demand.

Over time, the benefits resulting from this transformation will find their way into FLEX’s trading multiple. If we look at the universe of publicly-traded EMS peers, those with the highest margins, revenue growth, and exposure to non-traditional sectors like PLXS and BHE garner high-teens EPS multiples while those on the other side of that spectrum like Hon Hai, Quanta, CLS, JBL trade in the 10-12x range.

So far, this transformation stuff seems pretty unequivocally positive, but there is one drawback which is that it takes a tremendous amount of time and discipline. It takes time to build up design capabilities, it takes time to convince customers that you are worthy of engaging in a deeper relationship, and it takes time to establish a beachhead in non-traditional industries that are not used to outsourcing their manufacturing. It also takes discipline to invest resources for years in these capabilities while the rewards lay far ahead in the future and discipline to divert resources from the legacy EMS business that could otherwise give you a near-term revenue boost. The way I see it, FLEX has been under-earning for years as they invested in these capabilities that they are only now starting to see the benefit of. Luckily for us investors, we now get to skip the vast majority of the painful investment phase, and invest right at the inflection point in the business.

We can tell we are near the inflection point in the business because a lot of leading and concurrent indicators are starting to inflect positively:

• HRS/IEI Bookings – in FY18 total incremental bookings for these segments were $3.7B, up 54% from $2.4B in FY15
• Sketch-to-scale penetration – inflecting to 40% of revenue by FY20 from 27% in FY18, much faster than recent pace from 21% in FY16
• Average product lifecycle – inflecting to ~6 years in FY20 from ~4 years in FY18
• Recent top-line surge in HRS/IEI – the last 2 quarters have shown a dramatic inflection in top-line performance:
  • HRS 2H18 organic growth at a ~13% rate vs. a ~4-5% rate in the prior 2 years
  • IEI 2H18 organic growth at a ~29% rate vs. a ~1% rate in the prior 2 years

Short-term Issues & the Entry Point:

Since hitting all-time highs in January, FLEX is down nearly 30% on a trifecta of issues and concerns (delay in Nike ramp, increased investment spending, accounting investigation) that came to a head on the Q4 earnings call in April - on that day the stock was down 22%. I will address these concerns and why I believe they will abate over the next 12 months.

Delay in Nike Ramp:

The investor base has been very focused on FLEX’s Nike relationship for a few years now. Essentially, FLEX is in the process of completely reinventing how Nike builds shoes in order to dramatically reduce production lead-times and allow for greater customization and is in the process of ramping up a large, highly-automated manufacturing facility for them in Mexico. This relationship is extremely strategic to Nike and they have routinely talked about FLEX in glowing terms and reiterated that they expect FLEX to be responsible for a material portion of their global production capabilities over time.

The original plan for the Nike relationship was that it would have a significant ramp-up period where FLEX would be generating negative EBIT in FY18, but that the relationship would shift to break-even by EOY FY18 and ramp-up to contributing meaningfully by FY20. Basically, FY18 has now passed without Nike reaching breakeven and the entire timeline has been pushed out 6-9 months, meaningfully impacting both FY18’s results and the guidance for FY20. Here is my estimate of what the push-out looks like:

The net result is that the Nike push out has impacted FY18’s results slightly, and has reduced FY19 and FY20 estimates by ~$0.10/sh or so.

Is this material? Of course. However, I think it is being given too much attention by the investor base because it is being viewed as a bellwether for the entire sketch-to-scale transformation rather than as a single (albeit large) relationship. As shown earlier, the broader transformation is very much still on-track. Furthermore, I believe this a true “push out” rather than a cutting of LT expectations from this relationship. It is notable that Nike’s COO came to the FLEX investor day in May for an entire Q&A section and reiterated how important the relationship was to them. He was adamant that Nike does not undertake “transactional” relationships, that they usually work with their supply chain partners for decades, and that once they get through the ramp-up, that they “will give FLEX as much business as they can handle.”

In any case, at this point expectations for FY20 have pretty minimal contribution from Nike and even getting to EBIT breakeven by FY20 would drive material EPS gains off of FY18 levels so I see this concern abating over the next year or so.

Increased Investment Spending:

The second major concern is the increased investment spending that FLEX is undertaking in the first half of FY19 and is the 2nd major contributor (after the delayed Nike ramp) to guiding towards a much softer 1H than investors were expecting.

In attempting to understand this factor it is important to keep in mind the nature of FLEX’s business, which is that they have a huge number of discrete contracts with customers. Each of these contracts has their own investment period and ramp-up period before transitioning into a profitable “harvest” period. While in a steady state those investment periods are netted off against the harvesting period of more mature contracts, FLEX is certainly not in a steady state right now given the inflection they are seeing in the business as a result of years of bookings and sketch-to-scale efforts starting to bear fruit. As a result, they are bearing the brunt of this investment period in 1H FY19, pressuring margins. This effect is magnified because a lot of the incremental revenue flowing through in FY19 and FY20 is for very long product-cycle business which necessitates more significant investment periods and longer ramp-up timelines. There are also some more discrete investment opportunities like expanding their India capabilities in response to incentives provided by the Indian government to produce more goods domestically.

I get comfort that this increased investment spending is temporary both because we can see the revenue growth and bookings that this investment spend is attached to, and also based on the degree of confidence that management has in the cadence of earnings through FY19 and in significant margin expansion in 2H19 (although given execution challenges lately obviously this needs to be taken with some skepticism). Furthermore, with the exception of large “game-changing” relationships like Nike, most of what FLEX is bringing on is low risk from an execution standpoint and they should have a pretty good idea of what their margin profile should look like.

Accounting Investigation:

The final investor concern here is that concurrent with FLEX’s Q4 release, they announced an audit committee investigation. They haven’t been able to give too much detail about this other than saying it was driven by allegations made by an employee that they improperly accounted for obligations in a customer contract and related reserves. While this is the kind of business where management discretion and estimates can come into play when recognizing revenue (so they could certainly play around with numbers if they wanted to do so), there are a few reasons why I believe this is relatively benign.

First, this allegation appears to be coming from a single whistleblower on a single contract – given the vast number of relationships that FLEX has, if this is isolated to a single contract it almost certainly is not material. Furthermore, when releasing their NT 10-K last week, FLEX merely repeated the same language they had used in the earnings release “at this time, the Company is not aware of any issues under investigation that will materially affect the fourth quarter or fiscal year results” and gave no indication that the investigation had broadened to other contracts – if this was a systemic issue where the investigation had broadened, I believe they would have disclosed it in the NT.

Second, the cash flow conversion and quality of earnings have historically been pretty good at FLEX – while this doesn’t affect the likelihood of improper accounting on a single contract, it does significantly lessen the possibility that this is widespread fraud or anything else that would cause me to materially reassess the earnings power of this business.

Finally, when filing the NT 10-K last week, FLEX checked the box which indicates that they expect to be able to file their 10-K within 15 days of its original due date, and also indicated that they have determined not to file the 10-K until the Internal Investigation is complete. Ergo, they currently believe that the investigation will be completed by June 14th. That fact, combined with the continued assertion that the investigation will not result in material impacts to Q4 or FY results suggests to me that the investigation is wrapping up and has not unearthed anything material.

Upside Optionality from JVs:

One element of the FLEX thesis that is often forgotten about, particularly with everything going on with Nike, the transformation, and the short-term issues described above, is that FLEX has JV stakes in a number of extremely promising software companies that they have helped develop internally. So far, they have disclosed the existence of four of these JVs:

1.       Elementum

• Supply chain management software incubated by Flex since 2012
• Flex owns 50% of the JV and has raised $67M of funding from reputable VCs, most of which was raised in early 2014
• Current revenue is nearing $100M
• If the VC investments have generated a 30% IRR to-date, would imply a $450M valuation currently, or a MSD EV/Sales multiple
  
  

2.       YTWO Formative

• Supply chain software for real estate developers
• Transaction platform for builders to source materials in a centralized manner
• 50% JV partner is publicly traded RIB software (RIB GR)
• RIB expects €1B of transaction volume on the platform by 2020; the JV will generate a 1% platform fee and FLEX will capture a cost-plus spread on volumes going through their “Flex Building Group”
• Can triangulate to ~$10M of profit contribution to FLEX by 2020, or ~$150M of value
  
  

3.       Escientia

• End-to-end provider for active pharmaceutical ingredients, from compound discovery to scaling the chemistry process, to reaching clinical-scale volume
• Jointly developed factory in India to produce these ingredients
  
  

4.       BrightInsight

• Digital health offering that can aggregate data and deliver insights to optimize connected healthcare devices
• Goal is to create a high-secure common architecture that can plug into a variety of data sources and physical devices

Both Elementum and YTWO could have material value. Elementum in particular drives $0.40/sh of value even at what I believe to be very conservative multiples for a high-growth SaaS company. YTWO probably triangulates into another ~$0.20/sh of value or so. If these initiatives are successful the upside could be much greater – I have seen sell-side analyses that ascribe close to $4/sh from these two JVs by 2020. Not only can these JVs have material value, but currently the investment into these platforms is running through the P&L and costing FLEX ~$0.05/sh annually – so any traditional multiples analysis is ascribing negative value to these promising businesses.

Management:

I’ll briefly touch on management. Despite recent execution missteps and some communication issues with the street, I believe this is a good team to back. Mike McNamara, the CEO, has run this company since 2006. He was amongst the first in the industry to put in place a focus on ROIC rather than growth and to pivot away from low-margin, low value-added businesses. He is the architect behind the current transformation and has invested considerable resources in building out FLEX’s sketch-to-scale capabilities. They have also allocated capital well and have been consistent buyers of their own stock, decreasing the shares outstanding by 35% over the last 8 years. Management is highly incentivized to perform well, with the CEO receiving only 9% of his target comp through base salary and 17% through bonus and the remainder through stock grants (39% performance based LTIs, 31% time-based LTIs). As a result, they are significant owners of the company – Mike owns 3.1M shares outright (0.6% of the company) and has exposure to another ~2.7M shares through unvested RSUs and PSUs. Other executives are similarly aligned. Finally, while historically management had been pretty steady sellers of their stock holdings (not surprising given the % of compensation that comes through LTI), as of late there has been almost no insider selling, which suggests management is bullish on the near-term prospects for FLEX.

Valuation:

I believe the risk/reward here is extremely asymmetric. Management has put out a revised guidance of $1.55/sh in FY20 earnings, below the original guide of $1.80/sh due mostly to the delayed Nike contribution and increased investments/ramp-ups required to support future revenue growth. The guide seems conservative to me (although no one will give them credit for this given current execution issues) and I believe management wanted to commit to just enough to make people happy after the Q4 debacle while still giving themselves an easy bar to beat.

I see a bear/base/bull case here as being $12/$21/$28, yielding very attractive upside to the current trading price.

Bull case:

• FY20 guide is conservative, we get 10% sales growth in FY20 (in-line with recent acceleration) instead of 6%, and they hit target margins ex-Nike = $1.75/sh
• At this point, looking at a MSD+ top-line growth rate and MSD-HSD EBIT growth given mix and Nike ramp, not hard to imagine 15x EPS
• Add in $1-2 for JV value
• 12-month Bull target = $28/sh ($1.75 x 15 + 1.50)

Base case:

• Hit FY20 guide, $1.55/sh with $0.05 drag from JV
• Get 13x multiple ex-JV – better than historical given strong growth and outlook, but some wariness given recent execution
• Add in $0-1 for JV value
• 12-month Base target = $21/sh ($1.60 x 13 + 0.50)

Bear case:

• Continued execution issues, FY20 small growth off of low end of FY19 guide = $1.30/sh
• 9x multiple applied – one turn discount to old 10x multiple given lingering accounting concerns
• No one cares about the JV stuff
• 12-month Bear target = $12/sh (1.30 x 9)

Risks:

• There is a risk that the accounting investigation is not benign and has a material impact on perceived earnings power
• Cyclicality – while FLEX has broadened their customer base and are less affected by sector-specific cycles, a broad economic downturn obviously is not great for this business model – they bear a lot of fixed costs and their margins are thin enough that they will be impacted in the event of meaningful revenue shortfalls
• Management credibility – this business is extremely difficult (if not impossible) to model from an outsider’s POV given the huge number of contracts and diversified end market exposure; as a result, this investment thesis necessarily relies on management’s forecasts and targets for revenue growth and margins

Catalyst

• Continued execution on sketch-to-scale opportunities
• Ramping of Nike business
• Lapping of short-term elevated investment period
• Resolution of accounting investigation