Flex Ltd. Q3 FY2021 Earnings Call

Good morning, and welcome to Flex's Third Quarter Fiscal 2021 Earnings Conference Call. With me today is our Chief Executive Officer, Revathi Advaithi; and our Chief Financial Officer, Paul Lundstrom. Both will give brief remarks, followed by Q&A. This call is being webcast and recorded. And if you have not already received them, slides for today's presentation are available on the Investor Relations section of our flex.com website. As a reminder, today's call contains forward-looking statements, which are based on our current expectations and assumptions and are subject to risks and uncertainties, so actual events and results could differ materially. Also, such information is subject to change, and we undertake no obligation to update these forward-looking statements. For a full discussion of the risks and uncertainties, please see our most recent filings with the SEC. Lastly, this call references non-GAAP financial measures for the current period. The GAAP reconciliations can be found in the appendix slides of today's presentation as well as on the Investor Relations section of our website. With that, I'd like to turn the call over to our CEO. Revathi?

Thanks, David. Good morning, everybody, and thank you for joining us today for our fiscal Q3 earnings call. I hope you and your families are healthy and safe. I want to thank all my Flex colleagues for their continued hard work and commitment. Our strong third quarter results are a true testament to the efforts of all my colleagues across the world. I'd also like to provide you an update on our NEXTracker business. As I've previously said, we continuously evaluate our portfolio positioning, improving the mix, finding and investing in great opportunities and taking a disciplined approach to maximize long-term shareholder value. The company is now actively pursuing alternatives for this business, which may include, among others, a full or partial separation of the business through an initial public offering, sale, spin-off or other transactions. As you can understand, there's only so much we can share with you today, and we'll continue to provide more information on this topic in the future. Our revenue was over $6.7 billion, up 12% sequentially and up 4% year-over-year. Our adjusted operating margin came in at a strong 4.6%. This figure includes the absorption of continued macro-related challenges, new product programs as well as the elimination of previously implemented austerity measures. Our adjusted EPS was $0.49, up from $0.38 in Q3 of last year. Our adjusted free cash flow came in at $289 million, demonstrating another strong quarter in free cash flow generation. These are very strong results. Fiscal Q3 is historically our strongest seasonal quarter, but we executed even better than our prior expectations as we navigated the challenging environment and delivered to meet improved demand. This led to sequential and year-over-year revenue growth in both our reliability and agility segments, with 5 of our 6 business units growing sequentially as well as year-over-year. Our health business is well positioned for continued growth, as we invest in new program ramps and our chronic care products continue to ramp this quarter. We also saw a slower-than-expected decline in COVID-related critical care products, unfortunately due to the resurgence in COVID cases. Automotive benefited from a stronger-than-anticipated global recovery, led by North America with improvements in all regions. The team has been working very hard to deliver in a difficult macro environment, but they continue to make progress. We see a very bright future, particularly in our growing electrification and autonomous businesses. Industrial improved sequentially as expected on continued strength in core industrial. However, we still faced a year-over-year decline due to a customer-specific headwind in power solutions as well as a tough comp related to safe harbor in renewables. Both of these items are transient. We remain confident in the secular drivers in both of these spaces, and there's absolutely no change to our market positions. Our agility segment performed very well across the board, capitalizing on important long-term secular drivers in areas such as cloud and 5G, along with a shift to premium brands in mid- to high-end products in our lifestyle business. We also continue to benefit from the recovery in consumer spending, which led to a solid holiday uptick as well as continued spending related to work and learn from home. The teams executed very well to meet strong demand while driving productivity and focusing on the right kind of growth. This led to improved profitability and growing revenue, which aligns with the goals we previously laid out. I'm very proud of the strong results we achieved this quarter. However, this is no time for us to take our eye off the ball. We have all read the latest headlines on the devastating impact from the COVID second wave. So far, there have only been a few regional lockdowns, such as in Malaysia and Brazil, but our number one priority remains to protect our people and their families. We've also heard about the confluence of events leading to increasing supply constraints in everything from semiconductor components to transoceanic shipping containers. This has created additional uncertainty in a number of end markets. We have anticipated and managed through these latest challenges, and we'll continue to monitor this rapidly evolving situation. Rest assured, these are near-term potential challenges, and overall, we continue to see an improving environment and growing opportunities. I want to touch on ESG as it is an important focus for Flex. Flex currently ranks number one in the electronics manufacturing sub industry and is in the top 50 out of almost 13,000 companies globally as rated by Sustainanalytics. We launched and closed our new $2 billion sustainability-linked 5-year revolving credit facility on January 7, replacing our previous $1.75 billion facility. Flex is the first company in the tech space to have an ESG-linked loan, with the pricing linked to Flex's performance in meeting specific ESG key performance indicator targets, namely greenhouse gas emissions reduction targets and work-related safety incident rates. I look forward to discussing ESG in more detail on our Q4 call. With that, I'll turn the call over to Paul, who will walk you through our results in more detail. I'll then come back at the end to share some closing remarks.

Okay. Great. Thank you, Revathi, and good morning, everyone. If you could please turn to Slide 6. Flex revenue was $6.7 billion in the quarter, which was up 12% quarter-over-quarter and up 4% year-over-year. Q3 was stronger than expected, with top line growth in both the agility and reliability segments and broad strength across the portfolio. Adjusted operating income was up 22% year-on-year to $311 million, with 60 basis points of margin expansion. Profit growth was bolstered by stronger volume with a good mix, as well as productivity and efficiency gains. I want to remind everyone that this figure continues to include some headwinds from COVID-19 costs. Our adjusted net income was $251 million, with adjusted earnings per share of $0.49, both up 30% and 29%, respectively, year-on-year. To reconcile adjusted net income to net income on a GAAP basis, third quarter GAAP net income of $208 million was lower than our adjusted net income due to $25 million of stock-based compensation, $13 million in net intangible amortization, and $4 million of net restructuring and other costs. On a gross basis, restructuring was $30 million in the quarter, partially offset by $26 million of other investment gains. We continue to track to the targets we outlined in Q1 and still expect to close to about $100 million of restructuring costs between Q2 and Q4. Our third quarter adjusted gross profit was $514 million, up $55 million year-over-year. Adjusted gross margin was up 50 basis points to 7.6%, a record performance for Flex, reflective of strong execution in the quarter. In total, adjusted SG&A spending was flat from a year ago and 3% of sales. We continue to believe our repositioned cost structure will provide meaningful earnings leverage as we execute on our long-term growth strategy. Summing it up, adjusted operating income of $311 million was up 22% year-over-year, and 60 basis points of margin expansion led to a record 4.6% operating margin rate. Flex Reliability revenue on Slide 8 was $2.9 billion in the quarter, up 8% sequentially and up 2% compared to a year ago. Q3 performance for all 3 businesses in Reliability met or exceeded our initial expectations going into the quarter. Automotive, in particular, benefited from the industry's ongoing strong global recovery as demand improved substantially from trough levels last spring. Automotive revenue was up high single digits year-on-year, with improvements seen across all regions led by the Americas. As expected, Health Solutions sales were up double digits year-over-year. Critical care products, diagnostics, and patient monitoring programs continue to be in demand, with perhaps a touch more volume than we expected. Lastly, industrial was down high single digits compared to the prior year. As mentioned last quarter, a customer-specific headwind and a tough comp in renewables, related to safe harbor, created some pressure in industrial but was partially offset by strong growth in the balance of the business. Turning to profitability. Flex Reliability Solutions generated $178 million of adjusted operating profit and a 6.2% adjusted operating margin, which was down 40 basis points year-on-year, due to headwinds related to automotive product transitions and investments associated with new product ramps in Health Solutions. Flex Agility revenue of $3.8 billion was up 16% quarter-over-quarter and up 6% year-over-year. Within Agility, Lifestyle was the standout for the quarter, up 10% year-over-year, thanks to continued strength in the high-end audio, floor care, and appliance end markets. CEC performed better than expected, up low single digits year-over-year, led by cloud and critical infrastructure, while enterprise IT spending remains muted in line with the broader market. Lastly, consumer devices grew high single digits year-on-year, benefiting from seasonal upticks in consumer spending and demand. Flex Agility Solutions generated $153 million of adjusted operating profit and a 4% adjusted operating margin, driven by strong volume and mix. For the quarter, stronger earnings and favorable working capital again drove sequential growth in operating cash flow, while adjusted free cash flow of $289 million also benefited from disciplined CapEx. We target 80% or greater free cash flow conversion on an adjusted basis. Looking ahead to this fiscal year ending in March, we expect to achieve roughly 80% free cash flow conversion on a non-GAAP basis, with adjusted free cash flow over GAAP net income likely closer to 100%. We closed Q3 with inventory of $3.7 billion, which was up 2% sequentially but flat year-on-year, resulting in inventory turns of 6.8x, up half a turn from a quarter ago. We are seeing significant component constraints and are working diligently with our partners to secure needed parts and fulfill demand. Our net capital expenditures for the quarter totaled $65 million. We continue to efficiently manage CapEx while supporting the strategic goal of increasing our technology and capabilities in higher-value end markets. We resumed our buyback program during the third quarter after it had paused since March due to the preservation of our strong cash and liquidity position. We made the decision to return to the market as visibility continues to improve. We also have a $2 billion undrawn revolver, which we entered into on January 7 of this year, replacing the existing $1.75 billion revolver that was set to expire in 2022. This was the first ESG-linked credit revolver agreement in the tech industry, tying the cost of the facility to key metrics supporting Flex's long-term sustainability plan. Overall, we are pleased with our balanced and flexible capital structure, which enables us to meet our current and future business needs, while remaining investment-grade rated. Before we get into guidance, I want to reiterate what we've said previously about operating in a dynamic environment while protecting the health and safety of our workforce. We do see component shortages as a headwind in Q4, and we have contemplated those effects in the guidance I'm about to share. Our guidance is based on our current visibility information available today. Regarding Flex Agility Solutions, we expect revenue to be up low to high single digits year-over-year, with Lifestyle expected to be up high single digits to low teens year-over-year, reflecting sustained demand for products that support remote work and school. CEC is expected to be up low to mid-single digits year-over-year, with critical infrastructure demand balanced by muted enterprise IT spend. Consumer Devices is expected to up low single digits compared to last year. For Flex Reliability Solutions, we expect revenue to be up low to high single digits year-on-year, with automotive revenue to be up low to mid-single digits year-on-year. Health Solutions will be expected to be up low double digits to mid-teens year-over-year in Q4 with continued growth from new program ramps. Lastly, our Industrial business will be up low to mid-single digits year-over-year from strong growth driven by core industrial and power products. Given these outlooks, we would expect our quarterly enterprise revenue to range from $5.6 billion to $6 billion. Adjusted operating income is expected to range from $225 million to $265 million. Interest and other estimate is roughly $40 million, and we think our tax rate will remain in the 10% to 15% guidance range. Adjusted EPS is in the range of $0.32 to $0.38 per share, based on weighted average shares outstanding of 508 million.

Thank you, Paul. I want to reiterate that I remain extremely confident in our strategy and execution. Some challenges over the last 12 months demonstrated the increasing value we provide to customers. Production in multiple geographies, scale and expertise in managing complex supply chains, along with design and engineering capabilities, contribute to helping our customers build impactful products. Increasingly, companies are realizing the advantages of partnering with Flex, and this value will only grow as we continue to invest in technologies to thrive in higher-value markets. On behalf of the entire leadership team, I thank our customers for their trust and partnership and our shareholders for their continued support. With that, we'll start our Q&A.

My first question, Revathi, just regarding your outlook for the March quarter. What you said reflects some conservatism relative to expectations on component constraints. Is that coming from customers? Are you starting to see some rescheduling or orders pushed out because of that? Or is that more internal in terms of your own outlook?

Matt, thank you for that question. I would say it's twofold, right? We're not seeing push out of demand from customers at this time, but we see the inability to deliver some components from our side due to supplier constraints. We are also seeing customers experiencing shortages with other suppliers, which constrains the entire supply chain. We haven't seen any order cancellations from customers; only shifts, which is an evolving situation on a day-to-day basis. So we've taken all that into account.

Just related to that in terms of your working capital and inventory. Are customers asking you to start placing some inventory for out quarters? We're hearing this from several component suppliers and distributors in terms of very strong book-to-bill ratios. How does this impact near-term cash flow?

One thing we learned last year was to manage incoming demand from customers effectively, using intelligence to help them make decisions while being realistic with supplier demands. Our last quarter's inventory performance reflects that. However, we are seeing a so-called bullet effect due to shortages, with lead times extended and orders exceeding needs, creating ripples through the entire supply chain. We're seeing more orders than we believe necessary, which could lead to excess inventory in the system. We are considering this in our working capital metrics for Q4.

To comment on the guidance, there is a little pressure on the top line, potential cost headwinds from logistics and others affecting the P&L, and some conservatism in the cash flow outlook due to inventory issues. Therefore, sales, cost, and the balance sheet could all potentially be adversely affected in Q4, all accounted for in the guidance.

I can pick up on the earlier questions regarding supply chain. Given the broad role Flex plays in the tech and macroeconomic landscape, do you expect the peak of the supply issue to be in the calendar first quarter, or could it worsen beyond March?

Mark, that's difficult to assess as it depends on the specific component in question. For instance, a chip shortage takes time to ramp up, and projections suggest that could extend into the second half of the calendar year. Assembly and test capacity may improve toward the end of calendar Q1 and into Q2. It's hard to predict how all components will interact, but late Q2 may provide some clarity on supplier capacities.

Can you provide an update on the NEXTracker business concerning revenue or EBITDA? Given the upside, is the run rate different from what was described previously? Additionally, what key factors are you considering to maximize shareholder value with that asset? How long might this decision take?

We expect revenue to be over $1 billion with operating margin aligned with industry peers—double-digit margins. In terms of strategic alternatives, we will take a disciplined approach to evaluate what makes the best sense for Flex and our shareholders. The urgency in this process is present, but no specific timeline is set as we assess our options.

Has anything changed regarding your approach to unlocking the value of NEXTracker, especially since Flex wasn't previously known for such actions? Is there potential for further hidden value?

Our focus has been operational, ensuring we execute and consider portfolio management long-term. The evaluation of our portfolio and how we want to change our mix is crucial to our strategy moving forward. We have gained market share and plan to continue doing so.

Can you break down the 60 basis points of year-over-year improvement in operating margin? What are the implications for margin targets over the next year or two, and is the 4.6% margin sustainable? On Health Solutions, will the double-digit growth continue, or is there potential for slowing growth?

The margin growth was driven by strong volume and mix, along with some productivity gains. We believe good mix and volume efficiency can sustain 4.6% margins. As for Health Solutions, we may see an air pocket as COVID-related demand declines, but the base business is expected to continue growing in double digits for the next few years.

The base business is projected to continue growing in double digits, aiming for a healthy booking trend. We plan to invest in reliability to ensure long-term success.

In light of the potential NEXTracker monetization, what is your updated view on M&A in the industry? Is there potential for M&A to make sense in this environment?

The current industry does not need new capacity, and our focus will be on productivity and efficiency within our existing operations. We will consider M&A in higher-value technology in the reliability space, particularly in Health Solutions and automotive.

How do you see the change in administration influencing Flex, particularly in terms of infrastructure and global trade priorities?

We hope the Biden administration will support sustainability measures that align with our business. On trade, we seek less aggressive policies with China that still focus on IP and security. Onshoring trends will continue, which Flex can support due to our manufacturing capacity worldwide.

Can you provide insights into the relative growth rates of the end markets on the industrial side, particularly renewables, industrial devices, capital equipment, and power systems?

In Q3, renewables had headwinds due to a tough comparison and were in the double digits. Power grew mid-single digits, while core growth was strong. For Q4, we expect the renewables business to be flattish but anticipate overall positive growth across all segments.

Despite challenges, all segments are expected to experience positive growth for fiscal year '21, which is a significant achievement given the COVID context.

Regarding the reliability solutions margins, they declined 50 basis points sequentially on higher revenues. What do you see as headwinds going into Q4, and should we expect this as a long-term issue?

The automotive side will be a watch item due to component shortages. The margin headwinds observed due to product transitions and investments in new products should be temporary as growth resumes in Health Solutions and automotive revenue stabilizes.

We want to continue investing in reliability and ensure it gets significant support, setting us up well for the long term. Our margin profiles are expected to evolve positively as we focus on these strategic investments.

There are no further questions at this time.

Thank you for joining us today. I'm excited and confident about the future for Flex. The performance we delivered in Q3 and our guidance for Q4 reflects positive momentum. I wish you all safety and good health, and I look forward to speaking to you again next quarter.

Ladies and gentlemen, this concludes the Flex Third Quarter Fiscal Year 2021 Earnings Conference Call. Thank you for participating. You may now disconnect.