Description

FLEX Ltd. [FLEX]

I think enough new information has come out in the last year on both FLEX and NEXTracker to warrant a fresh take. Mason had a great writeup last year, so please look to it for more background. I will give a quick summary of the thesis and more importantly the short-term and long-term catalysts for the stock. FLEX filed confidentially this week to take NEXTracker public. Short term there is potential for a $30 stock and long term it could reach $50 as the new CEO executes her plan.

Thesis Summary:

FLEX is one of the largest electronic manufacturing (EMS) companies in the world. Two years ago, the company hired a new CEO who instituted a turnaround plan to improve margins, customer quality and free cash flow. The company eliminated $1.2B of poor margin business and re-emphasized their higher margin Reliability segment which now comprises the majority of earnings. 

Our fund was a large shareholder at a smaller EMS company, which focused solely on high-reliability (Hi-Rel), regulated markets. They successfully grew revenue and EBITDA in the double digits for multiple years. Through our years of involvement with this company we came away with the opinion that Hi-Rel EMS is actually a growing, profitable and less cyclical business than the market gives it credit. For FLEX, this includes outsourced manufacturing for medical, automotive, and industrial products which have high barriers to entry, and long product life cycles. Renewable energy is a particular focus for FLEX and they own a business called NEXTracker which is the global market leader in solar farm trackers.

Trackers allow solar arrays to tilt and follow the sun throughout the day which optimizes the power generation for the solar farm. Given the oligopoly nature of the tracker market and the expected growth of utility solar power, NEXTracker could command a significant valuation as a standalone company. Last year, their primary competitor, Array Technologies (ARRY) went public and this week FLEX filed confidentially to take NEXTracker public. Using similar multiples as Array, NEXTracker could be worth half the market value of FLEX currently on a pre-tax basis or $7.50 per share after tax. Our diligence calls with solar developers, EPC's and advisors to sponsor equity have come back very positive for NEXTracker. At the very least, it has a reputation on par to slightly better than ARRY. At less than 12x this year’s earnings, the market is giving FLEX almost no credit for this valuable asset. Additionally, FLEX has lots of exposure to other growth sectors like electric / autonomous vehicles, 5G rollouts and additional renewables (Enphase and SolarEdge are a few of many high growth customers). Given the high quality of the management team and the growth / margin-profile of their Reliability segment, the remaining FLEX business should trade closer to higher value peers like Plexus. If that happens, then you could easily have a $30 stock once you factor in NEXTracker, a greater than 70% return from current prices. Longer term, Reliability will come to dominate the company and the goal is to push towards 10% operating margins as they develop their IP. That should cause a further rerating for FLEX to a market earnings multiple and upside to $50/share.

Short Term Catalysts:

• NEXTracker has confidentially filed to go public. ARRY multiples imply nearly $7.50/share of value.

• FTC Solar is another tracker company that recently went public at 7x sales….implying further upside.

• This upcoming Q4 report should include more guidance for FY2022 and progress on their sustainability initiatives.

Long Term Catalysts:

• Proliferation of electric and autonomous vehicles. As I will detail later in the write-up I think FLEX is one of the better ways to invest in the growth of EV’s via their differentiated auto group.

• Medical business continuing it’s double-digit growth with the ramp of a glucose monitoring facility that should add $400mm of revenue and has been four years in the making.

• FY 2023 Growth rate of 6% and earnings power approaching $2/share vs. consensus growth of only 2% and $1.65 of earnings.

• Margin enhancement of the industry overtime leading to higher multiples for the group.

NEXTracker (2020 Revenue of $1B and potential value of $7.50/share to FLEX) 

NEXTracker is the leader in utility scale solar tracking solutions with 32% market share. In October of last year, its primary competitor Array Tech (ARRY) went public and FLEX management gave the following financial details on NEXTracker for the first time:

“Revenues currently north of $1B and double-digit operating margins similar to peers”.

Utility scale solar installations are expected to have annual double-digit growth for the next few decades. In the US along, it will require 75GW of new renewable energy capacity annually for the next 30 year to fully decarbonize the grid….in 2020 we did 20GW. This will require massive amounts of new solar farms, the vast majority of which will eventually run on trackers. However, as you can see below, tracker penetration significantly lags fixed tilt. Given recent cost and performance gains, trackers today provide 25% generation gains with only 7% increase in costs vs. fixed tilt solar. IHS estimates tracker installs to grow 17% through 2024 as solar installs grow and trackers take share. NEXTracker grew shipments from 11GW to 13GW in 2020 bringing their cumulative installs to 50GW in the last six years. We think that 20% growth should be a good estimate for 2021 considering ARRY is guided to 23% growth. 

Given FLEX’s comments and industry growth profile, we estimate NEXTracker 2021 revenues of $1.2B, $200mm EBITDA and $0.20-$0.30 per FLEX share of earnings. Lots of moving parts in these assumptions and it will depend on semi-shortages which I will touch on, but this is a good estimate.

Using blended multiples for ARRY, this implies almost $4.5B of pre-tax value for NEXTracker. Using FTCI revenue multiple implies nearly $8B of value….almost 80% of FLEX’s market cap.

As you can tell from my other VIC posts, we follow the renewable energy markets closely and have built a favorable view of the tracker industry through our developer, EPC and tax equity contacts. This is generally an oligopoly market with NEXTracker and ARRY holding nearly 50% of the global share and dominating the US markets with over 2/3rds share. One utility contractor we spoke with described them as “Coke vs. Pepsi” in the North American market. Given the relatively low cost of trackers and extremely high cost to plant downtime if they fail, we think this part of the solar equipment space is fairly “sticky” and the brand names will be able to maintain margins and market shares.

A general rule of thumb is that trackers cost around 7 cents/watt for utility scale. Assuming $1/watt total project cost it’s not insignificant, but going with a cheaper, unproven tracker company to get 10-15% cost reduction is only gaining you 5-10bps of yield improvement. Not a compelling reason for an EPC to roll the dice on an unproven supplier especially if there are first year performance guarantees and associated losses could whip out the construction profit.

For these reasons, the large allocators generally have approved supplier lists and NEXTracker is always on them. D.E. Shaw has somewhere close to 80% of their book on NEXTracker and they will spec equipment down to the washer to reduce risk.

There are some tech differences between NEXTracker and Array, namely Array uses a single motor to tilt multiple rows while NEXTracker uses a system which tilts rows individually. Both have their pros and cons. Array is faster to install, has less pain points and generally leads to a faster commissioning time. NEXTracker has slightly more precision with their system and is a bit better suited for large module, bi-facial panels which is where the large solar installs are going. In fact, they are approved on +100 of these new PV module types which should help their growth profile over time. Also, their True Capture software, which optimizes tracker performance via weather and other AI driven data (besides just following the sun) is proven enough to be written into performance guarantees, which should add to their moat. 

Similar to Array, NEXTracker has patent protection for the next 15 years and has been successful in defending their IP. But the real advantage is the 50GW deployed in the last 6 years and the trust that comes with the track record. NEXTracker and Array will continue to win their fair share because they are “bankable” for every financing source in the solar market and with backlogs exploding, there’s not much reason to hold up projects by trying a competitor. That’s not to say, there won’t be other players in the space. A company called GameChange solar is making some good strides. But I think the Coke vs. Pepsi analogy will hold for quite some time and NEXTracker and Array will be successful.

Remaining Segments: FLEX has simplified into the two reporting segments below. I will focus primarily on the Reliability segment and give a very brief overview of the Agility segment.

Reliability: LTM Revenues of $10.35B (44% of Revenues, 63% of Adj-EBIT)

This segment is the major growth engine for the company and is split between Auto (30%), Medical (20%) and Industrial (50%). Over 2/3rds of FLEX’s design work is done in this segment and LTM Adj-EBIT margins are over 6%. As explained before, Hi-Rel can be a very sticky business but takes lots of time to build up. Critical systems for medical products or cars have strict safety parameters and the product CANNOT fail because it could be life threatening for the consumer. For these reasons, once a manufacturer has been designed into a given system, it’s very hard to replace them and the switching costs are high. We assume Reliability will grow 10% given the growth profiles of its segments: Auto (8.5%), Medical (10%), Industrial (7%) and NEXTracker (20%).

Auto: $3B annual revenue, +13% historical growth rate from 2020-2012

If you ask around in the EMS circles everyone will tell you auto is a bloodbath. The OEM’s are horrible customers and the work is commoditized. However, after 20 years of moving up the value chain, FLEX has transformed into a tier one supplier and is in excellent position to benefit from the coming global transition to electric (EV) and autonomous (AV) vehicles.

Their auto revenue is split equally between traditional EMS, design work and product sales via their internal IP. Inhouse products include battery and converter technology which is key to EV and hybrid designs. For example, their proprietary 48-volt DC-DC bi-directional converter is essential for pairing higher voltage batteries with existing low voltage vehicle electrical systems. This 48V hybrid solution has been shown to generate up to 70% energy savings at just 30% of the cost of alternatives and they are ramping production with a European OEM currently. Battery management systems (BMS) are another example. FLEX has been designing BMS for 10 years in datacenter applications and are now applying this to the auto space. Other design work includes collaborations on ADAS and LiDAR systems (see recent partnership with LeddarTech).

Of the $2T in stimulus from the Biden infrastructure bill about $175B is designated to benefit electric vehicles via charging stations and customer rebates. Obviously, the OEM’s and tier one suppliers are taking notice. According to companies like Borg Warner and Vitesco Technologies, EV’s will have a 20% CAGR for next 10 years and 60% of all vehicle production by 2030 will be electric. NXP Semiconductors, which specializes in components for smart vehicles, estimates that fully electric autonomous cars will take semiconductor content per car from $350 to $1760…a 5x increase over 10 years. So not only will EV production be growing double digits, but as the cars get smarter they command increasingly complex sensors and electronic systems….a perfect storm of growth for EMS firms. FLEX should benefit from this trend as their content per car is highly correlated to general semiconductor content per car (see below).

The problem with OEM’s like GM or Tier 1 suppliers like Borg Warner is the crossover problem. Actual vehicle production won’t grow very much as EV’s accelerate and gas powered cars decline. However, FLEX can directly benefit from this trend with minimal to no cross over risk. Despite low single digit production growth in the industry, FLEX has growth revenues 13% historically.

There is a component shortage hampering the industry at the moment (and I will touch on this more later), but IHS still forecasts global auto growth of 14% in 2021. Given the dual opportunity of EV growth and content per car growth, we expect FLEX to grow this segment between 7-10% going forward. FLEX is making a big push into EV’s and there is a reason companies like ChargePoint are giving testimonials on their website. FLEX is the best way to play the adoption of this trend.

Medical: $2B Revenue, +10% historical growth rate from 2020-2012

FLEX’s medical portfolio has also been growing double digits since 2006 and is poised to continue that trend going forward. FDA approvals for medical devices usually have to be recertified if you change a manufacturing process or partner. Hence, this business is very sticky and FLEX is essentially “designed into” the products which include complex devices like infusion pumps, robotic surgery tools and glucose monitoring devices. That last category is a huge opportunity for FLEX. They setup a vertically integrated facility four years ago to manufacture glucose monitoring devices for a large medical client. This has been a drag on margins for years, but will begin production this year and grow to $400mm of revenue once fully ramped up. This project alone will provide 7% topline growth for the next few years, making our 10% annual growth rate conservative. Top clients include Philips, Abbot and J&J. Medium term growth rates for the med device portions of these top clients are close to 10% and they continue outsourcing more manufacturing to companies like FLEX. Given these trends, our 10% growth rate for the next few years should be very attainable. 

Industrial: $5B revenue which includes NEXTracker

Beyond NEXTracker, FLEX has a formidable customer base of renewable energy companies. Enphase and SolarEdge have publicly spoken about their heavy utilization of FLEX as a manufacturing partner. The same macro drivers for NEXTracker are pushing growth for the inverter and module businesses above 20% and FLEX will continue to benefit from these tailwinds.

Beyond renewable energy, this segment also houses their semi-cap equipment business. This acts as a nice hedge to the component shortage issue and backlog for new semi-cap equipment should be exploding higher. TSMC recently stated they plan to invest $100 billion in new fabs over the next three years. This is in addition to Intel’s recent announcement they plan to spend $20 billion on two new fabs in Arizona and President Biden looking for $50 billion in his announced infrastructure and stimulus bill for U.S. semiconductor manufacturing. These tailwinds are incredibly bullish for the industrial segments growth which we estimate will be around 7% going forward.

Agility: LTM Revenues of $13B (56% of Revenues, 37% of Adj-EBIT)

I won’t dwell too much on this segment, but will say that after the $1.2B of low margin business has been purged from this unit, it’s a much better business than people give it credit for. Last quarter for instance, it posted a 4% adj-EBIT margin which is higher than many standalone EMS companies can produce. Yet many analysts notes, like Goldman, value Agility at 8x earnings or lower. We believe this segment should grow at least 3% annually and be valued above 10x earnings for the following reasons:

• Total growth will be in the single digits and move around with GDP, but macro drivers like 5G rollouts will provide opportunities for higher growth. Ericson and Nokia are major FLEX Agility customers and will be growing their network infrastructure businesses at double digit rates for the foreseeable future. FLEX is a large beneficiary of the global 5G rollout.

• FLEX continues to win design work in this segment like their partnership with Dyson. They bundled design, proprietary electronics, and battery packs with full product assembly. FLEX will continue to emphasis the design/partnership model.

• This is a game of scale and assembling Lenovo and HP consumer equipment is commoditized, however FLEX has the heft and supply chain prowess to make money in this business even if it is lower margin.

Industry/Sustainability/Shortages:

After owning a smaller peer in this space for many years, we’ve come to appreciate how rationalized and sensible this industry has become. All of the CEO’s who wanted to grow for growth’s sake have been fired and the public EMS companies are marching towards higher margins, improved ROIC metrics and more predictable earnings. Moving towards regulated markets and away from commoditized manufacturing should have a very positive impact for multiples in this industry. The TAM for high value EMS work is around $100B today, but is increasing rapidly as outsourcing trends continue in the regulated markets which still perform roughly 70% of their manufacturing in-house. We think the average multiple in the EMS space moves closer to 15x-20x overtime as this theme plays out.

Within the publicly traded peers, FLEX is easily the farthest along with their sustainability strategy. Looking at any of the ESG rating metrics (MSCI, Sustainalytics, etc.), FLEX ranks at the very top of the industry and the public peers are a long way behind. Last year, FLEX was one of the first tech companies to close on a sustainability linked term loan. FLEX will be rewarded for lowering their carbon footprint over the life of the 5 year $2B loan which could lower borrowing costs by almost 1%. Last month, FLEX announced their intention to cut their CO2 emissions in half by 2030. Given the pressure on firms to reduce their carbon footprints, we think this will be a differentiator and growth driver for FLEX going forward.

One of the major risks for FLEX and industry this year is the current shortage in semiconductor components. There are hundreds of articles about this online, but the main issues stem from a steep drop in demand during covid, a realignment of resources within semiconductor manufacturers, and finally an even steeper snapback of demand. This is most impactful in the auto sector where FLEX has considerable exposure. However, despite the nonstop news cycle about auto plant closures, IHS still estimates production growth of 14% in 2021 for the auto industry. In our experience, good EMS firms find a way to grind through shortages and maintain margins. Just look at PLXS’s results and comments last month. Revenues could get lumpier and orders could get pushed out, but demand is in excellent shape. To quote AutoNation’s CEO on their Q1 call, “I've been saying it for over a year that there has been a pivot, a seismic shift, and I think this demand shift towards personal vehicle is very strong….shipments and production are disrupted with the chip crisis and will be for the rest of the year. But it's nothing like a year ago during pandemic when we had the factory shutdowns. Our shipments this second quarter will be double what they were a year ago. So it's on the margin as far as shipments. But the headline is more demand than supply.”

Valuation:

As you can see from the comp table below, FLEX trades at only 11x calendar year earnings while closest peer JBL trades at 10x. Ex-NEXTracker value of $7.50/share, FLEX is trading at 6-7x earnings. And a 12% forward FCF yield that should grow at +20%. FLEX should trade to $30/share considering full value for NEXTracker and 15x earnings for the remaining business. It could reach $50 if earnings are valued on a market multiple.

RISKS

• Component shortages hampering growth.

• New CEO leaving….Revathi is a Rockstar and will be in high demand if she turns the ship at FLEX.

• NEXTracker IPO doesn’t create value…could happen in the short term if there’s muted interest in the public markets or NEXTracker growth is less than peers.

Catalyst

See catalysts section