Flex Ltd. (FLEX) Q3 2020 Earnings Call Transcript

Good afternoon, and welcome to the Flex Third Quarter Fiscal Year 2020 Earnings Conference Call. Today's call is being recorded. At this time, for opening remarks, I would like to turn the call over to Mr. David Rubin, Flex' Vice President of Investor Relations. Sir, you may begin.

Good afternoon. Thank you for joining Flex' Third Quarter of Fiscal 2020 Conference Call. Slides for today's discussion are available on the Investor Relations section of our flex.com website. Joining me on today's call with some introductory remarks will be our Chief Executive Officer, Revathi Advaithi; and our Chief Financial Officer, Chris Collier. Today's call is being webcast and recorded and contains forward-looking statements, which are based on current expectations and assumptions that are subject to risks and uncertainties, and actual results could materially differ. Such information is subject to change, and we undertake no obligation to update these forward-looking statements. For a discussion of the risks and uncertainties, see our most recent filings with the SEC, including our current annual and quarterly reports. This call references non-GAAP financial measures for the current period that can be found in our appendix slides. Otherwise, they are located on the Investor Relations section of our website along with required reconciliations. Now I'd like to turn the call over to our CEO. Revathi?

Thank you, David, and welcome to your first Flex earnings call. Good afternoon, everyone, and thank you for joining us today. I am excited to provide some context regarding our strong results for the third quarter and update you on our progress during this dynamic and transformative period for Flex. First, I want to express my gratitude to all our Flex employees worldwide who continue to fulfill our commitments to our customers while working diligently to increase value for all our stakeholders. I sincerely thank our employees for their efforts as well as our customers for their ongoing partnership. Now, let's move to the third slide. Over the past few quarters, I have shared the initial direction of our company strategy and our business management approach. As promised, we look forward to discussing our strategy in more detail at our upcoming Investor and Analyst Day on March 11 in New York City. Today, however, I will concentrate on the third quarter financial performance, which I am pleased to report met our goals and guidance. We achieved revenue of $6.5 billion, driven by continued growth in our industrial sectors, and automotive and energy businesses, along with progress in our mix strategy execution. Our adjusted operating margin was 4%, reflecting our focus on disciplined execution and portfolio management. We also delivered a record adjusted EPS of $0.38, exceeding our Q3 guidance range, and generated adjusted free cash flow of $238 million, demonstrating our commitment to operational discipline and enhanced execution. I want to begin by addressing the coronavirus outbreak. Our primary concern is the safety of our employees and their families. We have deployed response teams to take proactive measures to assist our employees, and we will adapt as necessary as the situation develops. We are closely monitoring this evolving situation and striving to minimize business disruptions. We are supporting official efforts to contain the outbreak and are fully cooperating with government officials in China. We also aim to contribute to this cause through the Flex Foundation. It is still too early for us to quantify any potential impacts as the situation evolves, but I want to assure you that we have a comprehensive plan and will manage the situation diligently. Now, moving to the fourth slide. Our Q3 results reflect our ongoing management approach. By enhancing our mix and profitability, we have maintained disciplined execution and pursued design-led opportunities while managing our cash flow and capital allocation. This strategy is precisely what we discussed three quarters ago. We have effectively executed on our business mix strategy and cost management, enabling us to meet our commitments and continue investing in technology and design expertise. I believe our focus has strengthened our position in significant macro trends and future growth markets, such as electrification and 5G. This will ultimately lead to profitable growth, which is a crucial element of our strategy. As I engage with current and potential customers, I am energized by the growing opportunities to partner and create value for them and for Flex. We aim to address our customers' most critical manufacturing challenges and aspire to be a market leader in our sectors. I want to share some recent examples of wins that highlight our capabilities across our businesses. In our Q3 results, our industrial and energy segment remains exceptionally strong, bolstered by solid business wins. One notable project involves a complex capital equipment project where we provided engineering and design for large mechanical frames and interconnect systems, as well as support in designing the human-machine interface. Our regional manufacturing capabilities were key differentiators, allowing us to meet customer needs in both North America and Asia. In our automotive business, despite global economic challenges, we have made significant progress. We recently secured a major deal in China with a local OEM and expanded our position in electrification by winning an integrated battery management solution for a German OEM. These wins showcase our ability to leverage technical expertise across our automotive, power, and computing teams. By collaborating early and utilizing our extensive capabilities, including connectivity and power management, we provide valuable solutions to our customers. I would like to emphasize our commitment to four critical areas: managing our mix, executing with discipline, winning more design-led business, and consistently driving free cash flow. I am confident that combining these elements with the appropriate growth will be central to our strategy. Our performance this quarter and throughout fiscal 2020 clearly demonstrates our ability to deliver on our commitments. This consistent performance will enable us to focus on profitable growth and invest in our long-term strategy. While there is still much work to be done and further potential to unlock, our steady performance over the last three quarters positions us well on the path to profitable growth. Overall, I am very pleased with our performance this quarter. We are making strides toward our goals, and I am confident that our positive momentum will continue. I'll now turn it over to Chris for our quarterly financial results, after which I will return for closing remarks. Chris?

Thank you, Revathi. Please turn to Slide 6 for our third quarter income statement summary. Our third quarter revenue totaled $6.5 billion and was above our guidance range. Our Q3 adjusted operating income was $256 million, which was above our guidance range and remained roughly the same year-over-year despite a $461 million decline in revenues. Our adjusted net income was $193 million, resulting in adjusted earnings per share of $0.38. This was up 10% year-over-year and was above our guidance range. Third quarter GAAP net income of $111 million was lower than our adjusted net income primarily due to $19 million of stock-based compensation, $14 million in net intangible amortization and $49 million in net restructuring and other charges. Now please turn to Slide 7 for our quarterly financial highlights. Our third quarter adjusted gross profit was up 1% year-over-year to $459 million, while our adjusted gross margin improved a healthy 60 basis points year-over-year to 7.1%. This represents a third consecutive quarter of year-over-year gross margin expansion, reflecting improved operational execution and a richer mix of business. Our adjusted SG&A expense increased 3% year-over-year to $203 million this quarter, resulting in SG&A as a percentage of revenue to be 3.1% as we continue to manage with strong cost which provides us sustainable operating leverage. We continued to improve our profitability and our operating margin by managing portfolio mix, improving operational performance and sustaining cost control. This quarter, our adjusted operating income was $256 million. Our year-over-year adjusted operating margin expanded by nearly 30 basis points to 4%, which reflects our sixth consecutive quarter of year-over-year margin expansion. Now turn to Slide 8 for our third quarter business group performance. Each of our business groups either met or exceeded our revenue guidance. HRS revenue was $1.2 billion, up 3% year-over-year, driven by automotive growing 7%, which offset a 1% decline in health solutions. Automotive grew as we continued to scale multiple new programs across its portfolio. Health solutions was modestly weaker as new business growth was offset by lower demand from certain legacy programs. Revenue for our IEI business grew 20% year-over-year to $2 billion, which exceeded our prior guidance of up 10% to 15%. IEI experienced broad strength across its portfolio, with notable growth from our energy customers as well as growth in home and lifestyle programs. CEC revenue declined 17% year-over-year to $1.9 billion, which was better than our guidance and reflective of reduced demand from certain telecom and networking customers as well as the impact from our Huawei settlement, which was completed last quarter. Lastly, CTG performed as expected as revenue declined 25% from the prior year to $1.3 billion due to the effects of reducing our exposure to high-volatility, low-margin, short-cycle businesses and our targeted CTG portfolio repositioning activities. Turning to profitability, we were pleased to deliver adjusted operating profit above our guidance and to expand our adjusted operating margin to 4%. HRS generated $82 million of adjusted operating profit and a 6.6% adjusted operating margin. HRS margin was a function of the mix of its business and reflects the ongoing ramp of our largest-ever health solutions program as it moves towards full-scale production in fiscal 2021. IEI set a record quarterly adjusted operating profit of $124 million and pushed its adjusted operating margin to 6.3%. It continues to benefit from good commercial discipline and a richer mix of business with greater design and engineering content. CEC delivered $53 million of adjusted operating profit and a 2.8% adjusted operating margin as management took distinct actions to adjust CEC's cost structure and it also benefited from improved sequential revenue contribution. Finally, CTG posted a 1.8% adjusted operating margin as it remained pressured during our portfolio transition and ongoing repositioning of its operating structure. Turning to Slide 9, let us review our cash flow generation highlights. Our third quarter performance displayed strong cash flow execution. We continue to operate with good discipline over our net working capital and our capital expenditures. Net working capital this quarter benefited from favorable timing for customer payments and a continued improvement in our inventory management. This quarter, we ended with $3.7 billion or 56 days' worth of inventory, down 5% or 3 days year-over-year. We remain focused on further inventory management improvements as we drive multiple actions across the company. Our net capital expenditures totaled $55 million for the quarter, significantly lower than depreciation. We are operating with control over our CapEx spend, and this quarter, we benefited from $49 million in proceeds as we continue to reposition and optimize our operating system. We are operating a well built out global infrastructure and are benefiting from prior years' investments that are now supporting new technologies, products and programs. We also continue to leverage our existing assets to redeploy installed capacity where it is needed among different sites and businesses, which is a notable strength of our global system. We remain confident that we are sufficiently invested to support profitable long-term growth in our higher-margin businesses. As we enter the last quarter of fiscal 2020, we expect that our CapEx will continue to closely align with our annual depreciation level, thereby benefiting adjusted free cash flow. This quarter, we generated $238 million in adjusted free cash flow. We have generated positive adjusted free cash flow for five consecutive quarters as we operate with discipline and strive to generate adjusted free cash flow conversion in line with our historical levels. We remain focused on our commitment of delivering shareholder return as we repurchased over 5 million shares for $61 million during the quarter and over 4% of our outstanding shares over the last 12 months. Lastly, we continue to operate with a balanced capital structure with staggered debt maturities and a relatively low average cost of debt. During the quarter, we issued $215 million of senior notes with a 10-year maturity and used proceeds and cash on hand to reduce our debt position by $200 million, which had the effect of extending our debt duration with minimal impact on interest expense. Please turn to Slide 10 for our fourth quarter guidance. Revenue is expected to be in the range of $5.8 billion to $6.2 billion and reflects more modest seasonality impacts than in prior years. HRS revenue is expected to be flat to up 5% as we anticipate continued auto demand growth as we ramp new programs coupled with a modest growth in our health solutions business. We expect sustained demand in IEI with 20% to 25% growth as it continues to experience broad strength across its portfolio in addition to ongoing new business ramps. CEC revenue is expected to be down 5% to 15% year-over-year, reflecting distinct reductions in customer demand due to actions undertaken earlier this year coupled with persistent muted demand in telecom and networking. For CTG, we expect revenue to be down 20% to 30%, reflecting the impact of targeted reductions of highly volatile products as part of our ongoing specific portfolio management efforts. Our adjusted operating income is expected to be in the range of $220 million to $250 million, displaying continued adjusted operating margin expansion. Interest and other expense is estimated to be between $40 million to $45 million. We expect our tax rate in the quarter to remain in the mid-range of 10% to 15%. Adjusted EPS guidance is in the range of $0.30 to $0.34 per share based on weighted average shares outstanding of 510 million. Our adjusted EPS guidance excludes the impact of stock-based compensation expense, net intangible amortization and the impacts from our remaining restructuring and other charges. As a result, we expect a GAAP earnings per share in the range of $0.19 to $0.23. Lastly, I would like to note that our guidance excludes any potential impact from the coronavirus outbreak given the rapidly evolving situation.

Thank you, Chris. After considering the fourth quarter guidance that Chris just provided, we now expect our annual EPS to be in the range of $1.25 to $1.29, which aligns nicely with our commitment from April of $1.20 to $1.30. Our GAAP annual EPS is expected to be in the range of $0.26 to $0.30 and includes stock-based compensation expense, intangible amortization and restructuring and other charges. Since last year, the Flex team has been working really hard to establish a consistent and sustainable track record that you can have confidence in. Our results in Q3 and for the first nine months of our fiscal year are evidence that we're moving in the right direction, and we are focused on the right areas of consistently executing, delivering profitable growth and then meeting our commitments. With that, I'm going to have the operator open the line for questions.

Your first question comes from the line of Paul Coster with JPMorgan.

A couple. First off, the CEC and CTG businesses. Do you have some sense of when, at least, the portfolio culling will be done in CTG and when you think both segments might stabilize?

Paul, thank you for the question. I'd say though in CTG, we have done a lot of planned actions in terms of changing our mix and the size of our portfolio, and I'd say that most of our work is done. But that being said, we should always be looking at our portfolio and trying to figure out the tail of the portfolio and see if there's a way to better manage it. I'd say in CEC, we've had a combination of portfolio actions and the market impact from our networking and telecom customers. From a portfolio action perspective, I'd say in CEC, the majority of our actions have been taken this year. We're continuing to look at the networking and telecom space from a market perspective and seeing how that plays out for the rest of the year. So as I step back, the one thing I would say from a portfolio perspective, Paul, is that in how we run businesses, we should always be looking at low-performing parts of our business and figuring out the right way to manage them because we want this relationship to be a win-win for our customers. I have confidence that we have done significant work already, but that doesn't change that we'll be keeping on looking at it on an ongoing basis.

My follow-up question has to do with the auto segment. We're hearing that the auto industry as it transitions from ICE to electric vehicles is interested in the idea of transforming its supply chain and moving away from its traditional suppliers to new manufacturing capabilities such as yours or the EMS space generically. Do you concur? And are you seeing a change in the scope of what they are allocating to you as a result of that, maybe a strategic shift?

Yes, Paul, thank you for the question. Yes, I think it's a well-known fact that the automotive space is going through clear market shifts and changes in terms of its supply chain strategy. I'd say that Flex is well positioned as the strategy evolves because we have strong manufacturing capability across the portfolio of electrification and autonomous, which are critical next-generation technologies. We also have really strong design and domain expertise around these platforms that are really important. So as we see the overall value chain and supply chain changing in the automotive space, I would say manufacturers like Flex, particularly, are well positioned in this space. Our early investments in autonomous and electrification will also significantly help in this regard. We're building a very collaborative business model across all our partners, not just in the hardware space but also the software space for both of these technologies. So Paul, I believe we're well positioned as the automotive supply chain evolves, and this presents an advantage for Flex.

Your next question comes from the line of Mark Delaney with Goldman Sachs.

Congratulations on the good results. I have a question on the unfortunate health situation in China, and you certainly realized the coronavirus impact is imminent at this point. But I think about 1/4 of Flex' manufacturing capacity is located in the China region. So maybe just operationally, you can talk about what Flex may be seeing with its own factories at this point in terms of any extended shutdowns? And what percentage of your factories may be impacted at this point?

Thanks, Mark. First, thanks for the comments on our results. We're quite pleased with our performance. I'd say on the coronavirus, first, like I said in my prepared remarks, the most important thing is making sure that our colleagues, our employees in our factories in China have the best possible help that we can provide, and we are very focused on that as the most important thing. That being said, our teams really know how to handle this type of situation extremely well. We have a very disciplined and detailed plan that we're executing right now for our customers and suppliers as we're looking at the impact on our factories. If you think about our overall presence in China, we don't have any factories in the Hubei province, where the bulk of the issue is. The number of people that we have deployed there and our assets have come down significantly due to our diversification efforts that we've taken in the past year. Our approach is a very disciplined one. We have detailed plans that are being executed across our factories already, and we're working with government agencies to see what the actual shutdowns are going to be and looking for exceptions wherever possible. So Mark, I'm comfortable that we have a game plan. That being said, the situation is evolving, and we're working every day to understand new information and act accordingly.

That's very helpful. A follow-up along the same lines. Maybe some of the tariff-related planning the supply chain had to go through over the last year is a reasonable case study for us to think about. When Flex has had to respond and make shifts in its manufacturing plants, maybe just remind us how long that could take. I know it's a complex question because you have so many different products and customers. But just talk about examples of how quickly Flex may be able to move between factories when it needs to. And is that usually something that needs to go through requalifications with customers, or can that be done relatively quickly?

Thanks, Mark. I would remind you that most of our supply chain strategies are driven by our customers, and we support them in their supply chain strategy. As they look at diversifying globally, we have been supporting our suppliers. Some can definitely move faster than others. For example, anything in our consumer segment, particularly the CEC segment, can move much faster than our industrial, automotive, or medical segments. So that's generally how you should think about our portfolio. Our real focus is on following our customers wherever they want to go. We're seeing customers driving dual-source strategies and having sourcing from multiple factories to de-risk their supply chain, and we're well positioned for that due to our significant geographic diversity.

Your next question comes from the line of Ruplu Bhattacharya with Bank of America.

And again, congrats on the quarter, very strong margins. My first question will start with that, specifically on the IEI segment. You reported, again, a very strong 6.3% operating margin, which is above the long-term range. Any thoughts on the sustainability of margins at this level? How do you see penetration into the industrial and energy end markets? Do you think you still have more penetration to achieve in these end markets? How should we think about segment margins over the next couple of quarters?

Well, Ruplu, thank you for your comments on our performance. We're very pleased with our IEI performance. As I said, across our energy segment and our base industrial businesses, we saw really good growth and conversion, which also comes from volume increases across this segment. My comment about margins is that our focus will always be on driving the right mix within every segment. The beauty of the IEI space is that the available market is significant. Even today, if you look at vertical integration within customers, it's still quite high. For us, being able to take products from customers and move them across our value chain presents a big opportunity. Our expectation is that IEI will continue to grow because the available market is substantial and it's aligned with the spaces we want to participate in. It has long cycles from a customer affinity cycle standpoint. We're also seeing growth in the energy sector in IEI, and our hope is to manage mix and find the right pipeline within this segment to improve margins as we move forward. So, it's a space that we're very excited about, and our performance so far proves that we can continue to ramp the segment in the future as well.

Okay. That makes sense. Maybe another question on margins for HRS. They came in a little bit lower than we expected, but 6.6% is still pretty high margins. Can you elaborate on some of the investments causing this? Or how long more investment is needed? How should we, again, think about segment margins over the next couple of quarters?

Thanks, Ruplu. Yes, we're bullish about our HRS segment. If you think about the two aspects of our HRS segment, automotive and health, we have amazing expertise and market leadership in both. Despite market headwinds, our automotive segment has continued to perform well from growth and margin improvement perspectives. Challenges in our health business are not due to bookings or growth but rather how we are ramping the businesses we have booked. We have booked many complex projects in this space. Those programs ramping up represent a tremendous amount of work for our operations team, and we're learning through that process. We're excited about our pipeline of bookings and the future potential for this business. We feel very comfortable and continue to focus on accelerating these program ramps and learning from them. We remain very optimistic about the potential of HRS as a whole.

Your next question comes from the line of Jim Suva with Citi.

This is Tim Yang calling on behalf of Jim Suva. My first question is on seasonality. I think the December quarter is the first time your performance was above normal seasonality in the past four quarters. You are guiding for the March quarter as slightly above seasonal as well. Do you think you've finished most of your portfolio optimization? How should we think about seasonality going forward?

Yes, sure. Thank you for highlighting that, Tim. Yes, for sure when you think about the guidance we just provided, it reflects a much more muted seasonality than historically. The five-year average indicates roughly a 10% March quarter reduction, whereas the midpoint of our guide is much lower than that. A lot of that is attributed to significant efforts this year to reposition ourselves and be thoughtful around high-volatility, short-product life cycle businesses, and that's what you've seen in the CEC and particularly in the CTG business repositioning. As a result, you will see a much more balanced depiction of the company's revenue as you move throughout the fiscal year.

Got it. That's very helpful. A quick follow-up question on automotive. Revathi, you mentioned new program ramps driving strength in automotive. In the past, you have had relatively high concentration with a couple of auto OEMs. For the new programs you're ramping, are they from your largest customers or from a more diversified customer base?

I talked about program ramps in both health and automotive, but automotive growth is driven by market share wins we have secured in this space. We're progressing well in our overall diversification strategy for automotive, both geographically and across customer bases, and that has been a focus for us as you've heard in the past. Additionally, the focus on electrification and autonomous vehicles is helping significantly as we're expanding our platform and content in these technologies. All of this is contributing to changing the mix of our automotive customer base. We feel really good about where we stand, and we'll continue this effort.

Your next question comes from the line of Adam Tindle with Raymond James.

Chris, I just wanted to start with a comment regarding this quarter's performance, which admirably held profit dollars flat despite a sizable decline in revenue year-over-year. It looks like revenue declines may be tapering based on your forward guidance, possibly on a path to revenue growth. On the other side of this, just wanting to understand how you're thinking about leverage for fiscal '21. For example, prior to this quarter, I think we were all embedding double-digit profit dollar growth on low single-digit revenue growth. Just trying to get a sense of a reasonable incremental contribution margin so that we don't get ahead of ourselves following this quarter and into the Analyst Day?

Thank you, Adam, and thanks for identifying some of the improving performance we have. We announced that our Investor Day is on March 11, and that will be a perfect time to dive deeper into our strategies and how we see each business's trajectory along with margin. From our year-to-date performance and guidance for Q4, the company can continue operating with discipline around its cost structure. Our SG&A has been well managed, enabling us substantial leverage moving forward. As we shift the business mix, you're now seeing us achieve a 7 handle for gross profit margin. We expect to continue operating with discipline and improve operational execution, putting together a trajectory you can have confidence in. However, we don't want to get in front of a growth trajectory or margin profile at this stage. We'll unpack that in detail during the Investor Day in a few weeks.

Okay, understandable. Maybe just another question on HRS to put a finer point on it. Last quarter, there were many moving parts. You had customer move-outs, and you were ramping large programs. This quarter, it looks like the revenue was there. The segment returned to growth for the first time in about four quarters but faced some sizable margin erosion. If I am embedding your guidance correctly, the next quarter margin will still have a 6 handle. Please correct me if I'm wrong there. If you could unpack the investments weighing on margins and the timing for those to settle would be helpful.

For sure. Margin for HRS, as I highlighted, is really a function of the mix of its business. We've extended into significant ramps in our health solutions area. Those will be foundational for future revenue growth, but at the front end of these types of programs, profitability and margin are typically lower than they will be as volumes increase. So we have shifts going on across that portfolio. While HRS margins continue to hold nicely, if not improve, I would not lose sight of the total company performance for Q4, which shows significant gross profit and operating margin expansion year-over-year.

Adam, I would add that the diversity of our portfolio is important. We can invest in program ramps and focus on complex programs that we are ramping in our businesses, converting our bookings to revenue in our HRS portfolio, and we'll continue to invest in that space. It’s the right thing to do, we can afford to do it, and it ultimately pays off well for us in the long term.

Your last question comes from the line of Matt Sheerin with Stifel.

Regarding the CEC business, you commented about continued softness in networking and telecom. I know you've got broad exposure there. What's your thinking in terms of the 5G cycle? Many peers have talked about a stall in 5G, and there seem to be inventory issues that have not yet played out. Any commentary or visibility would be helpful.

Yes. So Matt, overall, we feel very good about our positioning in CEC, whether it is with 5G in the telecom space, in networking, or even in the cloud and data center space. We have noted that there is a delay in 5G programs, which I discussed a bit last year. Regionally, Europe and Asia have slowed down significantly, while North America is ramping faster. Overall, we see 5G facing a bit of a slowdown, which is typical in large infrastructure rollouts. This is what we've observed. I'd say networking reflects more of a seasonality issue currently, and we continue to see slow demand from our customers, which we expect to persist in Q4. It's too early for us to predict when that will change, but we believe we're well positioned across all areas of CEC. We've always been market leaders in this space. Our unique capabilities in service, storage, wireless, and battery management have consolidated our position effectively. We see some market issues but overall, we are performing well.

And lastly, Chris, regarding your OpEx, it was a little higher than expected. You had a lot of revenue upside this quarter. What should we be thinking about OpEx as a percentage of sales? Should we be able to start working that down and get leverage from a better mix and gross margins?

Yes, sure, Matt. In Q3, OpEx was at $203 million, which was up modestly year-over-year, around 3%. We can operate with significant discipline in managing this line item. It will create meaningful leverage for us moving forward. We're confident in our ability to operate within a range of 3% to 3.2%, while supporting future growth and the required levels of investment. A step-up in this period was influenced by improved revenue and profitability, which led to higher incentive compensation. Overall, you should expect us to maintain this range with high confidence, providing meaningful leverage.

With that, I'd say thank you for joining us, and we're really pleased with our performance in Q3. Our consistent performance throughout fiscal 2020 supports our outlook, and we look forward to seeing you all in March during our Investor Day. We're excited to share more insights into our strategy and the future we envision for Flex. Thank you, everyone.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.