Sanmina Corp (SANM) Q2 2020 Earnings Call Transcript

Ladies and gentlemen, thank you for standing by. And welcome to the Sanmina Corporation's Second Quarter Fiscal Year 2020 Earnings Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Please be advised that today's call is being recorded. I would now like to hand the conference over to your first speaker for today, the Senior Vice President of Marketing and Investor Communications, Paige Melching. Ma'am, please go ahead.

Thank you, Ian. Good afternoon, ladies and gentlemen, and welcome to Sanmina's second quarter fiscal 2020 earnings call. A copy of our press release and slides for today's discussion are available on our website at sanmina.com in the Investor Relations section. Let me remind everyone that today's call is being webcasted and recorded and will be available on our website. You can follow along with our prepared remarks in the slides provided on our website. During this conference call, we may make projections or other forward-looking statements regarding future events or the future financial performance of the company. We caution you that such statements are just projections. The company's actual results could differ materially from those projected in the statements as a result of a number of factors. Most notably, the ongoing impact of the COVID-19 pandemic, which has and is expected to continue to reduce demand from our customers, interrupt the flow of components needed for our customers' products, restrict the type of products we can build for our customers, and create health risks to our employees. Other factors that could cause our results to differ from our outlook include adverse changes to the key markets we target, significant uncertainties that can cause our future sales and net income to be variable, reliance on a small number of customers for a substantial portion of our sales, risks arising from our international operations, and any other factors set forth in the company's annual and quarterly reports filed with the Securities and Exchange Commission. The company is under no obligation to and expressly disclaims any such obligation to update or alter any of its forward-looking statements made in the earnings release on this conference call and on our Investor Relations section of our website, whether as a result of new information, future events, or otherwise, unless otherwise required by law. You'll note in our press release and slides issued today that we have provided you with a statement of operations for the quarter ended March 28, 2020, on a GAAP basis as well as certain non-GAAP financial information. A reconciliation between the GAAP and non-GAAP financial information is also provided in the press release and slides posted on our website. In general, our non-GAAP information excludes restructuring costs, acquisition and integration costs, non-cash stock-based compensation expense, amortization expense, and other unusual or infrequent items. Any comments we make on this call as they relate to the income statement measures will be directed at our non-GAAP financial results. Accordingly, unless otherwise stated in this conference call, when we refer to gross profit, gross margin, operating income, operating margin, taxes, net income, and earnings per share, we are referring to our non-GAAP information. I now would like to turn the call over to Hartmut Liebel, Chief Executive Officer.

Thank you, Paige. And also from me, a warm welcome to our second quarter earnings call. In addition to Paige here today, with me is also Kurt, our CFO. The last weeks have been some of the most challenging, perhaps in all of our careers. I am particularly pleased with our exceptional management team. They have stepped up to the plate, managed wave after wave of operational adjustments, taking care of our customers who, on average, have been with us for 15 years, serving mission-critical high-complex end markets. So let me take this opportunity to thank our leadership team and, of course, thank you to all of our customers and key suppliers, who collaborated with us extremely well in the last few weeks. With that, let me pass on to Kurt, who will take us through the quarter.

Thanks, Hartmut. We started off the quarter strong and on track to meet our original outlook. However, as the quarter progressed, we started to be impacted by COVID-19. We first saw this as our employees in China were delayed in returning from Chinese New Year. Secondly, there were delays in our Chinese supply chain, which have been shut down as well and we supply to our operations worldwide as well as the operations of our customers. Thirdly, we saw the impact on the timing and cost associated with the logistics of the supply chain, especially freight. Finally, in March, we saw the impact of shelter-in-place and similar restrictions, on both our operations as well as the operations of our customers. The fact that many of Sanmina's products are considered essential and, as such, are subject to certain exemptions from shelter-in-place or similar restrictions helped mitigate the impact, but we were still affected. As a management team, we focused on what we could control, namely optimization of our cost structure, limitation of new capital expenditures to only the most essential items, and cash generation. With that, I'd like to walk you through the details of the quarter. If you could please turn to Slide 3. Second quarter revenue of $1.6 billion was down 13.6% sequentially and 9.1% lower than the midpoint of our original outlook provided in January. Again, this was primarily due to the impact of COVID-19 as we previously discussed. As you know, we withdrew our original outlook back in March. Q2 non-GAAP gross margin was 6.9%, down relative to the prior quarter. This was primarily the result of under-absorption due to lower revenue levels, manufacturing inefficiencies, and additional costs caused by COVID-19. There were certain limitations based on government mandates in certain geographies, which prevented Sanmina from optimizing our cost base for the lower revenue levels, which we would do in the normal course. Q2 operating expenses declined relative to the prior quarter to $62.8 million as we focused on reducing spending as the uncertainty around COVID-19 started to become apparent. Q2 non-GAAP other expenses were approximately $13.5 million. This was up approximately $9.3 million relative to the prior quarter. This was primarily due to a loss of approximately $5.1 million related to deferred compensation assets, primarily as a result of the decline in the stock market and other financial assets in the second quarter. This compares to a gain of $2.0 million in the first quarter. As a reminder, gains or losses related to deferred compensation assets have no net impact on non-GAAP earnings per share. Deferred compensation gains or losses are equally offset with corresponding increases or decreases in manufacturing and operating expenses. Finally, Q2 non-GAAP fully diluted earnings per share declined to $0.32 due to the impact of COVID-19 on revenue and gross margins. As the uncertainty related to COVID became evident, we limited new capital expenditures to only the most decentralized items. Net capital expenditures were approximately $16.4 million in the quarter. Depreciation and amortization was approximately $28 million. If you now please turn to slide 4, here you can see additional income statement details related to the quarter and the associated comparisons. If you now please turn to slide 5, I will discuss our two segments; both of our segments' revenues and gross margins were impacted by COVID-19 relative to our original outlook for the quarter. As you can see on the left, IMS segment revenue declined to approximately $1.3 billion, non-GAAP gross margins down to 5.8%. On the right-hand side, you'll see components, products, and services revenues declined to $327 million. Non-GAAP gross margins were down to 10.6%. Now please turn to slide 6, on this page you can see our revenues by end market. While many of Sanmina’s products are considered essential and, as such, are subject to certain exemptions to shelter in place and other restrictions, many of these markets were still impacted by the supply chain disruptions caused by COVID-19. If you would now please turn to slide 7, our balance sheet remains very strong. Despite the challenging quarter related to COVID-19, we generated approximately $136 million of cash from operations and approximately $119 million of free cash flow. Cash and cash equivalents were approximately $1.1 billion at the end of the quarter. Towards the end of the quarter, given the uncertainty related to COVID-19, we decided to draw down $650 million of our $700 million revolver. We did not use any of the cash last quarter, and we do not expect to use any of this cash in the third quarter. As I mentioned before, we generated free cash flow in the second quarter and expect to generate free cash flow in the third quarter. We continue to maintain a low debt to cash ratio of 0.9. Our term loan has a balance of $366 million and matures in November 2023. During the quarter, we repurchased approximately 2.4 million shares for approximately $61 million. For the year-to-date, we've repurchased 2.7 million shares for a total of $70 million. We will continue to be opportunistic in repurchasing shares. Inventory was up approximately $40 million and inventory terms declined to 6.9. This was due to the manufacturing inefficiencies and disruptions in the supply chain caused by COVID-19. Cash cycle days were 61.7. Non-GAAP pre-tax return on invested capital was 14.6. I would now ask you to turn to slide 8. Here you can see additional balance sheet details related to the quarter and the associated comparisons. Now if you please turn to Slide 9, we’ll discuss the third quarter outlook. While our Chinese operations are up and running and the Chinese supply chain is improving daily, we still foresee continued impact to our operations in the third quarter and the rest of the world. Although again, mitigated to some extent by the fact that many of the products we manufacture are considered essential. In addition, there remains uncertainty as it relates to the impact of shelter and place and other similar restrictions on our supply chain outside of China as well as on our customers. The impact of COVID-19 and the macroeconomic environment will continue to evolve as the quarter progresses. Again, as a management team, we will remain focused on what we can control, namely optimization of our cost structure, limitation of new capital expenditures only to the most essential items, and cash generation. Our outlook for the third quarter is that revenue will be relatively flat in the range of $1.5 billion to $1.6 billion reflective of the continued impact of COVID-19. Customer demand for the quarter is expected to be relatively stable with the exception of weakness in Automotive. We expect non-GAAP gross margins to be in the range of 6.4% to 6.9% as we continue to be impacted by COVID-19. This relates to under-absorption, continued manufacturing inefficiencies and additional costs. Non-GAAP operating expenses should be approximately $61 million to $63 million. We continue to be focused on reducing operating expenses given macroeconomic uncertainty. We expect non-GAAP operating margin to be in the range of 2.5% to 3%. We expect non-GAAP other expenses to be approximately $10 million. Our non-GAAP tax rate should be around 22%. We expect non-GAAP fully diluted share count to be around 70 million shares. When you consider all this guidance or outlook for non-GAAP earnings per share for the quarter is in the range of $0.30 to $0.40. Adjusting for an estimated stock-based compensation of $0.12 per share, GAAP diluted earnings per share is expected to be between $0.18 and $0.28. Again we planned to limit new capital expenditures to only the most essential items. We expect capital expenditures to be around $17 million, while we expect depreciation and amortization to be around $28 million. Finally, despite the continued impact of COVID-19, we expect to continue generating free cash flow in the quarter. As I sit here today, there are a lot of variables that are changing every day, as we manage through the COVID-19 crisis. Not only do I believe Sanmina has navigated through these well to date, I believe we are positioning ourselves well with our customers and our key markets to benefit during the ultimate recovery. And with that, I'll turn it back to Hartmut for additional comments.

Thanks, Kurt. So let me add my comments to what Kurt outlined. To set the stage, I think the firm ex-Sanmina is very much at the center of the COVID-19 crisis. To get through these challenges we need three things to work for us to run our business. Number one, we need logistics channels to bring parts into our centers and to ship to end customers. Number two, we need a functioning supply base. We may have 99 parts, but without number 100, which might be a golden screw, you cannot fulfill the order. And number three, and probably most important, we need employees to be in the factory, recognizing that some work can be done from remote offices. So we have to manage all three so we can produce and ship to our end customers. Seeing how our company worked through these issues under pressure and uncertainty tells me a lot about the Sanmina team and our company. Just like other multinationals, for Sanmina, COVID-19 also started in China. There we have a relatively small presence in two key cities. The local teams and our other retail teams rapidly rolled out waves of operational adjustments through our network. By the time the challenge has arrived in Europe and the Americas, we had learned a lot and were relatively well prepared. The primary responsibility is to keep our employees safe while building products that our customers need right now. For example, inside of one week we moved 7,000 associates to set up and work from home. Today we have ample protective equipment suppliers on hand, new protocols for how employees enter facilities, social distancing, and we know how to isolate possible infection cases ahead of time in the future. I hear from our customers they appreciate our transparency and our willingness to share our protocols with our customers to improve their very own procedures. So far we've had very few cases and it has been manageable. Obviously, we still experience major disruption adding additional costs and inefficiencies that we're working through. With regard to our supplier base, we greatly enhance the day-to-day monitoring, including financial strength measurements. We enjoy great collaboration with our customers and certain suppliers are unique to some customers. We experienced some delays and constraints, particularly in the medical space for PPE, monitoring tests in high demand by EMS personnel. But I think overall this additional layer of transparency of monitoring is making us a better company and our customers appreciate that. We experienced similar challenges with freight and cargo; as we all know, due to the drop in passenger traffic, cargo capacity is greatly reduced and very unbalanced worldwide. Freight prices have gone up. Working with clients, we are finding optimal routings; we are expediting for critical path, especially in COVID-19; really the production of test equipment and ventilators. Some clients have entered into partnerships with local or national carriers to accomplish exactly that. We manage the logistics for them with limited direct financial impact for Sanmina, but delays and timing of delivery of components can impact revenues and the efficiency at the manufacturing plants. So to me, the last few weeks demonstrated what mission-critical products really mean. For example, in cities with stay-at-home orders, we quickly documented to local authorities the essential nature of our work. Within days, we could restart manufacturing for many of our customers. This response speed was very much appreciated by our customers. This is really the mission-critical nature of our work, and as our experience showed, this is much more than a marketing slogan. Next, please refer to slide number 13. I want to share with you my observations about our end markets. We have limited visibility. However, I believe that our focus markets will be relatively stable to support our guidance, with the exception of automotive. As we know, production in the automotive sector has stopped very much worldwide and it's unclear about the timing and speed of recovery. We have some exciting new engagements on the medical side, for example currently with an exclusive manufacturer of a rapid 15-minute COVID test that received emergency FDA approval. So this is a very exciting development to be part of. For you, many local police stations, fire departments, and EMS personnel we build communication systems that allow frontline managers to respond with speed and confidence, even if the public networks are overloaded or down during emergencies. Our optical network customers are quite optimistic about their order book as communication bandwidth constraint is now something all of us can relate to almost daily. The defense industry's core demand is intact. Again, this is with the relative stability, recognizing that our customers and ourselves have to continue to work through supply chain logistics and personnel challenges, but hopefully those will be gradually coming down in the weeks and quarters ahead. So where do we go from here and what do I see happening in the near future as I look around the corner? For that, please refer to slide number 14. As you can see from the actions we have taken, we focus on protecting the institutional strength of Sanmina, that is our strategic customers, our people, and our partner network. So we're staying very, very close to our customers. Based on our performance so far, I believe that they have great confidence in our management team and our approach, which in turn gives our customers the confidence to partner with Sanmina even stronger when things recover. I believe the overall secular industry trend, which is partner network consolidation, with fewer partners and closer end markets, more regionalization, those trends are firmly intact. I think they also played to our strength. For example, as related to regionalization, we've always been organized along those lines. We serve as leading edge technology customers where we provide first, flexibility; second, speed to meet end market demands; and third, the best total value for our customers and that has been our success formula in the past, and I believe it also holds true tomorrow. If I may recap today's call and for that, please refer to slide number 15, which is the last slide in our deck. In Q2, we really focused on taking care of our people. Revenue and margins were significantly influenced by COVID-19. We focused on what we can control, free cash flow, where we generated nearly $120 million and finished with an industry-leading balance sheet strength with a cash balance of $1.1 billion. In terms of the outlook for Q3, we anticipate a revenue range of $1.5 billion to $1.6 billion, non-GAAP EPS of $0.30 to $0.40, and we expect to be free cash flow positive. While we're streamlining operations to prepare for any market challenges, we also focus on being prepared so that when recovery kicks in, we are ready to go and meet increased demand. Our seasoned management team is on top of things and has demonstrated enormous resilience. This is the same management team that worked through 2008, but the difference is that today we have a much stronger balance sheet and we reset our shock to the system is different but can also create opportunities. I think we have some very exciting years ahead of us. Here I want to express a big thank you to all of our employees around the world, to our supplier partners, and thank you to our shareholders and investors for your long-term support. With that, we can open it up for Q&A.

And our first question is from the line of Ruplu Bhattacharya from Bank of America. Your line is open.

Hi, thank you for taking my questions. You're providing guidance for the next quarter, which is great. However, I’m a bit surprised given the considerable uncertainty, especially since many of your competitors have chosen not to provide guidance. Could you elaborate on what factors are giving you the confidence to offer this guidance? It appears to be a fairly tight revenue guidance with a range of about $100 million, so what elements contribute to your confidence in guiding for the June quarter?

Sure, thanks, Ruplu, good question. I think it's somewhat reflective of the nature of the customer relations we have. We are always in close contact with our customers and probably even more so toward different levels of organization even more these days with our customers. The feedback we are hearing from them, combined with a pretty robust bottoms-up forecast, gives us the confidence to provide our estimates for Q3 based on the available information to us.

I appreciate that, and it's a solid guidance framework for us. For my second question, I understand you're expecting flat end market demand, except for automotive, in the next quarter. Could you provide more detail on the communications network? What did you observe in that market for fiscal Q2 in networking, optical, or wireless, and are the same trends continuing? When you mention flat, do all these end markets show similar trends as in the last quarter?

I think on the communications side, there are some puts and takes regarding what the end markets of our customers are thinking through. On the one side, obviously they're dealing with very similar supply chain and employee readiness challenges that I described to you in our call, and that you've heard from them directly. At the same time, they see actual market opportunities to grow their space, such as increased communication demand, increased bandwidth demand, increased storage demand, and so on. I think that's why the imbalance, our end customers in the communications space seem reasonably optimistic about their outlook for this space. That's why we would call this space right now stable and supporting our guidance.

Okay. Thank you for that. And for my last question I'll focus on margins. I think you reported a gross margin of 6.9%. You mentioned additional costs associated with COVID-19. How much was that in the quarter, and how should we think about additional costs associated with COVID-19 in fiscal 3Q? It looks like from the guidance you're guiding our gross margins down somewhat because it looks like the guidance, if I heard correctly, is 6.4% to 6.9%. So what are some of the puts and takes that are impacting gross margin in fiscal 3Q? Thank you.

Kurt, you maybe want to take that call.

Sure. There are many interconnected factors affecting margins. It all begins with volume, which decreased last quarter compared to the previous one and fell short of expectations. Sanmina usually adapts quickly to such changes, but the uncertainty and rapid spread of COVID-19 posed challenges. As I mentioned earlier, we face some geographic restrictions that limit our ability to cut costs. Under-absorption is a major concern, along with inefficiencies from having either too few or too many workers in the factory without the necessary parts available. When parts do arrive, we often need to work overtime to manage the influx, which adds further costs. Hartmut referenced freight and other related issues, all of which are connected. Looking ahead to Q3, we anticipate experiencing many of the same factors impacting gross margin, which is why we expect margins to remain flat or decline slightly alongside relatively stable revenue.

Okay. Thank you for the details.

No problem.

Ian, next question please.

Our next question is from the line of Christian Schwab from Craig-Hallum Capital. Christian, your line is open.

Great. Thanks for taking my question. On the supply side dynamic issues, can you quantify the difference between or call out any parts that have caused disruption or is it really just kind of travel logistics to get them?

You know, Christian, good question. It's really so widespread that the issues we had to walk through here at Sanmina have filters very much down to all of our supply base and so it's I think everybody across the board that raised levels of success to get ready again. It depends by location, depends by the region, and we've worked very closely with that supply base to make sure that when we have the authority to restart operations, we could do that under local government regulations. There was a lot of great collaboration, but I don't see it limited to a particular commodity; the issues are very widespread.

Okay. Thank you for that. And then as we think about the second half of the calendar year, you know, what are the puts and takes? You talked about stability in the customer base except for automotive this quarter. What are the puts and takes that we should be monitoring most closely, or you’re monitoring most closely to anticipate what the second half of the calendar year could look like?

We are focusing on balancing three key factors. One is ensuring employee readiness, which still requires some adjustments on a daily basis. It's crucial to have the right protocols in place for employees to return at different times when the recovery occurs. We are also working to optimize our logistics partners and speed up the arrival of parts at the facility, while maintaining close communication with our supply base partners. This is all about achieving optimization, and we will have a clearer picture once the recovery begins.

Great. And my last question, you guys expressed some customer optimism in optical regarding the bandwidth issues globally. Are there any other silos of strength? I know you have some cap equipment and a small exposure there, but is there any other pockets of strength that you know are surprising?

It’s a lot of puts and takes; that’s why we call the outlook for end markets as stable. The optimism about the 5G rollout is intact, but we've seen all the short-term issues impacting the timing around it. Kurt, anything else on that note?

No, I think that’s good.

And at this time, I'm showing that we have no other questions in the queue.

Thank you, Ian. So let me just take a moment here on behalf of our entire management team. I want to thank you for attending today’s call and thank you for the insightful questions. I hope that you and your family and your team members stay healthy. We very much appreciate your long-term support of Sanmina and look forward to speaking with you next time, which will be our Q3 earnings call. Thanks again and goodbye.

Ladies and gentlemen, this concludes today's conference call. We thank you greatly for your participation. You may now disconnect.