Flex Ltd. (FLEX) Q3 2022 Earnings Call Transcript

Good afternoon, and thank you for joining us. Welcome to Flex's Fiscal Third Quarter 2022 Earnings Conference Call. As a reminder, this call is being recorded. I will now hand it over to Mr. David Rubin. Please proceed.

Thank you, Grace. Good afternoon, and welcome to Flex's Third Quarter Fiscal 2022 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. This call references non-GAAP financial measures for the current quarter. 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. Lastly, with regard to Flex's NEXTracker business, as we've previously discussed, we announced that we confidentially submitted a draft registration statement on Form S-1 of the U.S. Securities and Exchange Commission on April 28, relating to the proposed initial public offering of its Class A common stock. The initial public offering and its timing are subject to market and other conditions and the SEC's review process. We made this announcement in accordance with Rule 135 under the SEC. Following SEC regulations, we will not make any further statements or answer additional questions on the NEXTracker filing at this time. With that, I'd like to turn the call over to Revathi, our CEO. Thank you.

Thank you, David. Good afternoon, and thank you for joining us today for our fiscal Q3 earnings call. Please turn to Slide 3, and I'll briefly review our results. We had another strong performance in our fiscal Q3, despite the anticipated challenges in the supply chain environment. We achieved revenue of $6.6 billion, up 6% sequentially and above the top end of our previous guidance range. I want to emphasize that this outcome was more about strong execution than easier-than-expected macro challenges. Total Flex's adjusted operating margin came in at 4.5%, also better than previously anticipated. Adjusted EPS was $0.50, up from $0.49 in Q3 of last year. By the way, that's another new quarterly record for us. Adjusted free cash flow came in at $31 million. I would just add that our results this quarter demonstrate the major progress we have made in our ability to adapt and overcome macro challenges quickly. Of course, our deep and long-standing relationship with our suppliers definitely helps us during times like these. We are proud of our strong performance, and it's yet another important win for the team. The consistency and continued acceleration of our performance over the last couple of years is driven by the diversity of our portfolio, along with our disciplined execution. Strong sequential growth in our cloud, communications, and industrial businesses as a result of our bookings growth and successful ramps of these new businesses. Our investments in optical and 5G technology, electrification products, and data center solutions are also helping to accelerate our growth this year. We also recently welcomed Anord Mardix to the team. This acquisition adds to our overall data center portfolio, which is a high growth vector for us. We're excited to see the combination of these investments and strong secular growth trends really drive our performance going forward. I will come back at the end and talk about our growth drivers in a little bit more detail, but now I'll turn it over to Paul to take you through the full financials and the guidance.

Great. Thank you, Revathi, and good afternoon, everyone. Let me just start by saying how impressed we all are with the team's execution and commitment to delivering the best possible service for our customers in such a challenging environment. So thank you all for the hard work. Beginning on Slide 5, please note, I will focus my remarks on the non-GAAP results. The GAAP reconciliations can be found in the appendix of the earnings presentation. Flex's revenue was $6.6 billion in the quarter, down 1 point year-over-year, but up 6% sequentially. Adjusted operating income was $298 million, down about 4% year-over-year and up 4% sequentially. Adjusted net income was $238 million, down 5% from the prior year period and up about 3% sequentially. And finally, adjusted earnings per share was $0.50, an increase of 2% year-over-year and 4% sequentially. On Slide 6, our third-quarter adjusted gross profit was $498 million, down $16 million year-over-year. Q3 gross margin of 7.5% was about 10 basis points lower compared to last year. In total, adjusted SG&A came in at $200 million, down $3 million from our prior year period and at 3% of sales is at the better end of our targeted range of 3% to 3.2%. Overall, adjusted operating income was $298 million, resulting in a 4.5% adjusted operating margin, down slightly, but strong performance considering the continued tightness in the supply chain and at the top end of our guidance. On Slide 7, Reliability revenue was $3 billion, up about 5% year-over-year. Demand was strong across each of the end markets. Adjusted operating income decreased 14% to $154 million with a 5.1% adjusted operating margin rate. In December, we were very happy to welcome Anord Mardix to the team. The impact on the financials was immaterial in the quarter, but we are quite upbeat about the potential and the impact it will have on growth in our fast-growing data center business. We continue to expect it to be accretive to adjusted EPS and deliver mid-teens EBITDA margins in fiscal 2023, which begins this April. Automotive revenue decreased mid-single digits in the quarter with healthy underlying demand offset by continued supply challenges. Health Solutions revenue was better than expected, but down slightly compared to the prior year, driven by tough comps related to last year's COVID-related critical care peak. Lastly, Industrial sales were strong, up mid-teens with growth across the board, including at NEXTracker, where we saw sales up high teens. Due to the global logistics headwinds, margins have been pressured at NEXTracker, but we view it as temporary. The cost pressure in NEXTracker is largely what drove the decline in Reliability margins. Fundamentals remain strong. Moving to Agility. Segment revenue was $3.6 billion, down about 6.5% year-over-year. The Agility segment delivered $163 million of adjusted operating income, a year-over-year increase of 7%, leading to a record 4.6% operating margin. Within Agility, CEC demand was very robust, particularly in cloud, 5G, and optical. But upside in the quarter was limited by component constraints, which led to a modest sales decline. In Lifestyle, revenue was up slightly despite the difficult comp driven by new product ramps, customer wins, and healthy underlying demand. Finally, as we indicated last quarter, Consumer Devices revenue was down double digits caused largely by a planned project completion. Turning to cash flow on Slide 8. Our net capital expenditures for the quarter totaled $119 million, and adjusted free cash flow was $31 million. This quarter, we paid out a net $523 million in cash at the close of the Anord Mardix acquisition on December 1. We had two changes to our debt profile in the quarter, totaling $709 million. In both cases, we took advantage of regional opportunities at very low rates to support our business expansion and approaching maturities. During the fiscal third quarter, we repurchased 5 million shares totaling $90 million. In total, for fiscal '22, we have spent $580 million, repurchasing roughly 32 million shares. At the end of the quarter, we had approximately $600 million remaining on our current Board authorization. Inventory at the end of the quarter was $6 billion. Inventory turns were 4.4, down from 4.8 turns last quarter. While we expect inventory to remain high in the near term, I'll reiterate Revathi's comments about strong end market demand. Chip shortages have customers waiting to fulfill demand, and delivering on customer demand remains a high priority. So as shortages abate, so will higher-than-usual inventory levels. All things considered, we're pleased with our free cash flow generation over the last several quarters, totaling $340 million fiscal year-to-date, and we continue to target free cash flow of approximately $500 million for fiscal 2022. Cash generation remains a priority. And in alignment with our stated capital allocation strategy, we'll continue to invest in key areas that will position Flex to capture growth.

Thank you. As you can see from Paul, another strong quarter and improved guidance for our fiscal 2022. In early 2020, when COVID was just unfolding, we held our first Investor Day since I came into the company. In the midst of uncertainty, we shared with you our long-term financial framework. As you can see here on Slide 12, we said we would deliver organic growth above GDP and get to mid-single-digit operating margins and EPS growth of 10-plus percent. Looking at our full-year guide of FY 2022, you can see we have accelerated growth even while lapping a major portfolio change in FY '20. And we have delivered on our long-term margin and EPS goals. Turning to Slide 13. We plan to have an Investor Day in late March, where we will discuss how the combination of our investments in commercial and technology capabilities, coupled with strong secular trends, will accelerate our growth potential. Technology transitions like 5G, optical, electrification, and point-of-care diagnostics continue to be major drivers for most of our customers. Flex's investments in these technologies have helped us win major programs and continue to position us strongly in this market. In addition to these technology transitions, the challenges of the last several years have solidified the need for robust global supply chains, so companies can deliver their products to market and meet customer commitments. Many companies have found that they can't effectively manage this by themselves. This need is expanding the total available market for supply chain and advanced manufacturing services. Now the desire to manufacture products closer to local demand is also becoming a priority. Again, only a few companies have the capabilities to accomplish this efficiently and on a global scale, and that is driving strong new business wins for us. Other secular trends we're bullish about include digitalization, data center growth, and infrastructure investments, driving growth in the energy sector in both residential and utility scale. Now these secular growth drivers have been fueling our pipeline and bookings growth, as you can see in this year's results. As I said earlier, the combination of our investments in commercial and technology capabilities has positioned us well to capitalize on strong secular trends and has accelerated our growth potential going forward. Now combined with our track record on operational execution, this will create strong shareholder value in the years to come. On behalf of the entire leadership, I want to thank our employees for their contributions and strong execution, and of course, our customers and suppliers for their trust and partnership, and our shareholders for your continued support. With that, I'd like to turn the call over to start the Q&A.

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

My first question is about NEXTracker. From the information you've provided, it appears that for the first three quarters of fiscal '22, NEXTracker's revenues are experiencing significant growth, around 10% year-on-year, compared to just 2% growth for the entire fiscal '21. What is leading to this strong growth? Do you believe this growth rate can be maintained moving forward? On the margin side, however, it seems you are facing challenges due to freight and logistics costs. For the first three quarters, the operating margin for that business is 7%, while it was 15% for the full year last year, which is about half. Is the logistics cost the sole factor affecting this? You mentioned you believe this situation is temporary. Why do you think that is? Is your business capable of passing on these costs, and does it typically take time to do so? Please share your insights on revenue and margin improvement for that business.

Yes, Ruplu, I'll start, and Paul can jump in. I'd say first is, I'll start with the growth question. Yes, obviously, strong growth comparison this year. And of course, last year, with COVID and things like that, things did get to a little pause in terms of solar and utility-grade installation. But I would say that the pipeline and bookings for that business have been very strong even through COVID times. And now as installations are coming back, you're seeing that reflected in our growth rates. We continue to be very bullish for that sector, not just because everything you hear about kind of energy projects that are going on around the globe, but also the infrastructure investments that are being committed to this country. So the pipeline is strong, bookings are even stronger, and the growth rate is expected to continue, if not accelerate, from where we are today. So I feel very, very good about it. In terms of margin, first, as I'll point out, our performance is much better than all the peers in this sector. So that's one. Second, I would say, we have talked about this before that we are able to pass on not just kind of steel inflation costs and things like that, but freight and logistics costs also. But there is a timing issue involved with passing those on. What you've seen happen with freight and logistics, Ruplu, is, of course, the inflation has gone up quarter-over-quarter. So as we are passing that on, there's also a catch-up that's required as we continue to see this inflation, including the availability of things like shippers. So I think that is a challenge we are facing, but we are very, very comfortable that this is transitional and that we will improve the margins of this business as we move forward. Our fundamentals are very strong. This is like any other business that has time in terms of passing this on to their system. So it's very similar to that. And we feel very comfortable that the fundamentals are strong, and they will catch up in terms of their margin rates as they move forward.

Okay. My second question is on the CEC business, specifically on the cloud portion. You mentioned that the demand from cloud was particularly strong this quarter. Some of your peers have seen in that business, customers move to a consignment model, and that has impacted their revenues. Are you seeing anything like that from your customers? Or from Flex's standpoint, are you building the whole rack? Do you think that this business can continue to grow as we look out into the next couple of quarters?

So first, I'll say our CEC business, if you recall, a couple of years ago, we did some pruning and correction in the CEC business. In the last year, we have invested a lot in terms of growing the cloud and the 5G business. You're seeing all that kind of play through in our growth associated with cloud and 5G. So we are feeling very good about our investments in the cloud business with all the major hyperscalers and colos. So feeling really good about that. I'd say in terms of the model itself, we usually let our customers drive kind of what is the right engagement model. It's usually a partnership approach to figuring out where is the best value, because whether it's a consignment model or not consignment model really depends on kind of where is the value driven, right? And so if we find that we are not having any value, then consignment model is the right one to do. So we like to have a partnership with our customers in collaboration to come up with the answer of what is the right model. So it's a balanced approach. We don't have a business where we kind of moved that around at a pretty significant scale as you have seen some others do it. I think we're very consistent in our approach to this. And we allow our customers to really figure out and work with us as to what is the model that drives the best value, and then based on that, we make the decision.

Congrats on the strong execution.

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

First question was on supply chain. Hoping you could provide a bit more clarity on what Flex has seen? I realize there's been supply chain challenges for quite a while now. At the same time, there's now the Omicron variant. So any incremental details you can share on what the company is seeing currently? And any expectations for how that may progress going forward?

Mark, I appreciate your question. My ability to predict outcomes is no better than yours. However, we have observed a significant amount of data, which aids our understanding of the situation. Suppliers and customers have suggested that supply issues might start to ease between late 2022 and 2023. Our perspective aligns with this, although we have not yet seen a substantial reduction in these supply challenges, which remain consistent. We have a large supply chain team of around 10,000 people who work closely with our suppliers to ensure our demand is met in a manner that works for us and our customers. Looking ahead, we believe that the latter half of 2022 and into 2023 appears to be a reasonable expectation, largely based on the capacity investments suppliers are planning to make. Our outlook is consistent with the broader industry perspective regarding this timeline. As for Omicron, the impact on our performance has been minimal because 85% of our 165,000 employees are fully vaccinated, and about 93% have received at least one dose. We've fostered a culture that emphasizes the importance of vaccination for the well-being of employees and their families, which has significantly contributed to maintaining our performance amidst the recent fluctuations caused by COVID.

That's very helpful. And my follow-up question was around the EV business and you alluded to it a couple of times in the prepared remarks, not just in the automotive business, but also industrial with charging. I was hoping you could elaborate a bit more on what you're seeing in EVs and the outlook there? And is it getting to a point where you can size how much of the company's revenue is coming from EVs?

Yes, we will discuss this further at our Investor Day, focusing on significant growth drivers like electrification. We have invested heavily in developing our portfolio of solutions for converters and are actively seeking partnerships for high-voltage inverters and our own battery management systems, as well as collaborating with core partners on long-range battery solutions. Our focus on electrification is substantial. Regarding autonomous vehicles, we have established strong relationships with major players in that space, and we expect to see increased momentum. This is becoming an increasingly significant part of our business. As traditional internal combustion engine vehicles decline, we anticipate that electrification and autonomy will contribute a disproportionate share of our growth. Our bookings this year have significantly leaned towards electrification. I am particularly encouraged by our success in China, which is a key growth market for electrification. We are committed to winning in this area not only in China but also in Europe and North America, ensuring our geographical distribution is well-balanced and not reliant on a single player or region. We are optimistic about our prospects and will provide more details in March at our Investor Day, where electrification will be one of our main growth themes.

Your next question comes from the line of Shannon Cross from Cross Research.

I have two questions. I'm curious, as we've moved past the holiday season, are you seeing any improvement in customer lead times? Have buying behaviors changed overall? Do you see customers able to plan a little bit better? I'm just balancing maybe a little bit slower non-holiday demand with obviously Omicron and everything else that's happened. And then I have a follow-up.

Sure. Maybe start with lead times and then I'll just talk about stocking levels, because I think that's kind of an interesting phenomenon too, Shannon. Particularly in the Lifestyles business as we've moved out of the holiday season, I would say no significant change to customer lead times. But what we are continuing to see is inventory at the customer or at the channel level continues to be very, very low. Our customers, particularly in the Lifestyle business, would like to see, I don't know, 6 to 8 weeks' worth of inventory, and they have somewhere between 0 and 2. So we do expect, as I mentioned in the prepared remarks, we continue to see strong demand signals in that business, in particular. And I think that, coupled with the need to replenish inventory is going to be a positive tailwind for us over the next couple of quarters.

I would like to mention that the Consumer segment, which we refer to as Lifestyle, is also experiencing a lot of reshoring efforts. This means we have capacity available closer to the end consumer, which is contributing significantly to our program and bookings increase. Overall, holiday lead times are being managed more effectively, and while ports are currently congested, they are clearing up. As Paul noted, inventory levels remain low, and the changes like reshoring are driving additional demand in this area.

Okay. And then I'm curious, Paul, if you think about how you're managing working capital and specifically inventory, which is obviously up, but just in general, given everything that's happened in the last couple of years, should we assume working capital needs to run at a higher level going forward with the more distributed manufacturing? Or is there a way over time to kind of work working capital back down again maybe as things normalize?

Yes. I do. To your point, I mean, inventory is running hot, and I think that will continue. But as we move into 2023, I do see inventory levels starting to normalize. I'll say our big priority right now is just meeting customer demand, and we need a higher level of inventory just to do that. But again, I think you'll see that ramp down as the supply constraints improve as we move through our fiscal '23 with inventory starting to come down then. And I guess I would also point to cash flow. Look, inventory is elevated, but we continue to generate positive cash flow and hold fast to our roughly $500 million in free cash flow this year. So I think we're managing it pretty well.

Your next question comes from the line of Steven Fox from Fox Advisors.

Two questions. First, on the Lifestyle business. I was wondering if you could give some more color around the new logos and portfolio expansion you talked about in the slides? And then secondly, Paul, I understand seasonality in the March quarter, but if demand is exceeding your ability to supply right now, why isn't the March quarter guidance closer to what you just posted in terms of December revenues?

Yes. So maybe I can take the seasonality question, and maybe you can talk to the label. On seasonality, just some data points for you. Historically, as we move from Q3 to Q4, it's in the past, been about a 10% step down from Q3 to Q4. That's based on, I don't know, the last 10 years or so. At the midpoint right now, we're looking at about a 3% sequential decline, better than what we've done historically. I think, driven by a couple of things, hopefully, some improving component shortages, but also driven by some customer ramps. So I think we feel pretty good about our Q3 to Q4 step. To your point, if we had unfettered access to chips, Q4 would be much, much higher. But we just, much to my chagrin, don't see this shortage challenge going away immediately here as we move into the first part of this calendar year. It's going to take several quarters to work our way out of it.

Steve, as we discussed for Q3, we estimated a significant portion of our supply from suppliers and worked to fulfill customer needs while managing our resources, which positively impacted Q3. We anticipated similar conditions for Q4, and we will apply the same strategy. We're providing revenue guidance based on our expected supply situation, and we are diligently collaborating with suppliers and customers to exceed those expectations. However, it is challenging to make a straightforward commitment in the current environment. We believe our guidance is reasonable based on what we observe, and we're continuously engaging with our suppliers to achieve better outcomes. In FY 2020, we shifted our focus from small logos and startups to larger ones, where we see a clear value add from our technology. Our strategy involves not just acquiring new logos, but also deepening our relationships with existing ones. For instance, we're concentrating on dispensing fluids projects within Lifestyle for large logos, leveraging our manufacturing capabilities to address the complex need for quality in dispensing liquids. Similarly, in Floor Care, we utilize our strengths as one of the largest manufacturers to enhance our presence. We've achieved remarkable growth in Lifestyle over the past few years by deepening penetration with existing logos, expanding into new geographies, and offering enhanced services for comprehensive lifecycle support. Our commitment to technology and manufacturing excellence is guiding us as we aim to penetrate new logos in this area, and we've experienced significant growth in this segment recently.

Your next question comes from the line of Jim Suva from Citigroup.

I believe Revathi, in her prepared comments, expressed satisfaction with the team’s execution and indicated that it was primarily a result of strong execution rather than improvements in supply chain issues. Revathi, could you clarify how you determined this to be the case? Is it simply because lead times for supply are still very lengthy? Additionally, how were you able to obtain the necessary parts and components when other OEMs seem to be having difficulties securing them?

Thank you, Jim, for that question. And yes, I think you have nailed it absolutely right in terms of why we're able to manage this. One is, I would say, my statement is absolutely correct because we haven't seen anything change in supply or demand, right? Supply is still pretty bottlenecked across all major components that we're looking at. And demand is very, very strong, right? And that is still the fact. So there are two things that help us in an environment like this. One is our scale, of course. Significant scale, which helps us have deep relationships with our suppliers. We work very closely with our customers to really understand how we prioritize, what is prioritized within the quarter, what we can bring in, what we should push out, and really work with our suppliers to say, is there substitution? Should we be looking at qualifying something different? All of those really help with our scale. We operate in over 30 countries with 100-plus factories. Every supplier we call will lift up the phone and give us top priorities. So we work in a real partnership between our suppliers, customers, and ourselves in a very complex environment. Hundreds and thousands of lines that we're moving around every single day. And then on top of that, what happens is the stuff we plan for it to arrive, Jim, doesn't arrive. What we weren't expecting to arrive, arrives, because of the boat stopping somewhere or a supplier not meeting their commitments. So the factories have to be super, super nimble in terms of stop, start and doing all of that. So that is also another fantastic capability we have. Our factory execution capability is exceptional. If we have the parts, there’s no question that we can get it done. So they're able to execute efficiently, as you can see with our results. And Jim, that's why I feel very comfortable saying that supply-demand hasn't changed. We are very focused on resourcing, redesigning for our customers, doing all of that as we adapt to the supply situation. And then our factories, I mean, what can I say about our factory execution? They have just blown it away with their fantastic performance.

And our last question comes from the line of Paul Chung from JPMorgan.

So regarding follow-up on free cash flow, should we anticipate more significant generation, perhaps in the first half of '23 compared to '22, or will we see more normalization toward the end of '23? How should we consider the seasonality of cash flow? I understand it's challenging to predict.

Yes. The current inventory levels are somewhat high, as I mentioned earlier. I anticipate that they will decrease over the next few quarters as we move into 2023. The positive aspect is that we have received cash advances from customers, which have helped balance out the impact of this inventory increase. As inventory levels decrease, the customer cash advances will also go down, creating a bit of a balance. Looking ahead to 2023, which we will discuss further at our Investor Day in March, I expect the seasonality to remain similar to previous years. Historically, we have seen stronger performance in the latter half of the year, and I believe 2023 will follow that trend.

And then, Paul, the only thing I would add is, a strong balance sheet. We're still in a fantastic position. Our focus is on meeting demand as we have said for our customers because we just want to really focus on delivering our best for them. In that time, I would say we're doing a fantastic job in terms of managing our cash flow, with a lot of support from our customers, who fully understand what we're trying to get done for them. So we're really pleased with where we are with it, and we think it stabilizes as the situation balances out. So really pleased with where we are.

Great. And then last question on component shortages. How are you kind of prioritizing certain customers? Are you prioritizing higher-margin segments? How are you dealing with those dynamics? And if you could also talk about some of the pricing dynamics? I believe you're passing on most of the costs, but is there any incremental margins you're capturing for prioritization of certain customers?

Yes. I'd say, Paul, that's a really important question. In terms of how we prioritize, we have a very in-depth analytical and focused approach with our customers and our suppliers that really drives prioritization. We don't prioritize based on margins or anything like that. We really focus on, can we get the product in? If we can get the product in from our suppliers, we will absolutely deliver the end product to the customers. Obviously, medical always gets attention from all our suppliers. That's just been the way it has been. But our prioritization is really focused on what can the supplier give us based on their capacity and capability, and we work very closely with our customers in terms of making sure that they understand the prioritization. I'd say in terms of price, the last year has seen tremendous cost changes, whether you think about freight or material prices associated with semiconductors and other materials. And we have a very collaborative approach with our customers. We really focus on sharing costs with them. They understand that we drive efficiencies very well, but they also have a role to play in terms of cost. They want us to do what's right for running our business and running their business. So it's a partnership approach in terms of how we share costs with our customers. That's how this industry works. And at this time like this, you have to be more tied at the hip so our customers understand what we are seeing and what is the role they have to play. And then where are the places we can drive efficiency and perform better in how we run. All of this is working, and you can see that in our results even in the last six months with escalating costs. We continue to use that same playbook with our customers and our suppliers.

Thank you so much, presenters. And ladies and gentlemen, this concludes today's conference call. Thank you all for joining. You may now disconnect.

Goodbye.