Flex Ltd. (NASDAQ: FLEX) was written-up in May of ’19, so we will focus on updates since then and other incremental points. For those not familiar with the business, FLEX is an electronics contract manufacturer providing vertically integrated supply chain solutions from design, manufacturing and supply chain logistics. They have facilities in over 30 countries and with just 18% of PP&E in China they will benefit from a growing tailwind of companies looking to diversify their manufacturing away from China and move manufacturing closer to end-demand.
We see June as the trough quarter given the Company’s auto exposure of 11%. Annualizing consensus numbers (which we believe are too low) for the June trough, FLEX is trading at just 15.7x consensus vs other industrials companies which trade at 20x+ trough. Looking out to FY23 (Mar YE), we see nearly $2 of earnings power which on just 12x represents 96% upside.
As mentioned in the previous VIC post, FLEX hired a new CEO, Revathi Advaithi, from Eaton where she was the COO of the electrical segment. Feedback and checks on Advaithi continue to come back very positive and after a year and a half under the helm, she has executed impressively. For example, under a challenging year for the industry, FLEX still reached their FY20 EPS guidance range provided at the beginning of the year. Based on Advaithi’s performance so far and our conversations with her and the Company, we expect FLEX to set a pattern of consistent beats-and-raises as they regain the trust of the street and investor community after missteps from previous management.
Since starting, Advaithi has significantly realigned their portfolio to focus on their higher-margin and longer life cycle Total Reliability Solutions segment (formerly their IEI and HRS segments), which consists of the industrial, auto and healthcare verticals. Along with this realignment, she has exited $1.2bn of business in the lower-margin and more-cyclical Total Agility Solutions (formerly their CEC and CTG segments), which comprises verticals such as PCs, mobile and networking. Since joining she has grown Reliability Solutions from 42% of revenue in FY19 to 53% in the most recent quarter, and we estimate will be above 58% by FY23.
This transition has temporarily depressed revenue growth. For example, while a consumer electronic product will provide revenue shortly after contract win, it will have a shorter product life span, lower margins, and a contract that may be put up for bid year to year. A car design win on the other hand may take 1-2+ years to ramp into revenue, but will have a much longer life cycle, higher margins, and contracts that are sticky and long-term. Previous management chased bad business, which boosted near-term revenue growth but at the cost of margins, cyclicality and customer churn. So, while Advaithi’s focus on longer life cycle business has temporarily depressed revenue in the near-term, she has positioned the Company for higher, more stable, and stronger-margin growth in the years to come.
Margin wise, in FY20, Reliability Solutions’ operating margin was 6.5% vs 1.9% for the more cyclical Total Agility Solution segment. FLEX continues to focus on design-led projects with customers where they work with the customers on the design of the project promoting greater margin (can carry 2x the margin as legacy projects) and customer stickiness:
“If you look at what's now happening in automotive, we're actually getting customers coming to us and paying for us to do design work for them because they recognize that we have a competence that has value, not only in terms of improving the design of their product, but we have some unique IP or unique know-how that can now help to actually build a product that they need for the future. And we're seeing that, for example, in our auto compute space.” (FLEX at Citi Tech Conf, Sept 2019)
We see upside to margins in both segments as they continue focus on design led projects, exit less profitable business, fill capacity and ramp certain projects such as their Continuous Glucose Monitoring project.
It is worth touching on their Medical Solutions vertical, ~$2.1bn of revenue in FY20 (11% of total revs), as they have been growing this at double-digits and expect strong 10%+ growth in the years to come off strong bookings. Industry estimates vary, but FLEX believes ~80% of HC devices are manufactured in-house providing a long runway of growth ahead. FLEX hired a new Head of Medical Solutions in April 2016, who’s strong early results have proven out in their bookings:
“So in 2018, we talked about sort of a step function in bookings going from $250 million to $300 million a year to about $500 million a year. In the last 2 years, we've seen another step growth in those bookings, where we've been closer to $1 billion in bookings in the last 2 years.” (FLEX at BAML Tech Conf, June 2020)
Additionally, as mentioned above, FLEX is scaling a sizable Glucose Monitoring project they won several years back this year. In the ramping stage, the project was a margin drag but the project is now scaling and they see it ramping to $400mm of revenue in the next couple years.
In the near-term, FLEX is working through Covid related supply chain headwinds and now has facilities largely up and running at full capacity. In the near-term, the Company has increased costs related to Covid, which they have offset to a degree through cost cut measures and will pass any longer-term lingering costs through to customers. Commentary on bookings has been strong, with a spike in demand in the medical solutions vertical due to Covid and tailwinds from WFH in their Data Center / Cloud vertical (7% of revenue). Additionally, they will benefit from the 5G build-out from customers Ericsson and Nokia – and will benefit from the share shift to those OEMs away from Huawei. In the industrial segment, they have seen strong demand from renewable energy and semi cap equipment. In their lower margin Consumer Technology Goods segment, some customers have seen a spike in demand as well, such as iRobot. With autos bottoming this quarter, we see a strong set-up for the 2H and next year.
FCF / Balance Sheet
With their manufacturing footprint built-out, the Company does not see the need for growth CapEx in the near to medium term. Consequently, they expect CapEx to be at or below depreciation in the coming years and expect to return excess cash flow to shareholders through share repurchases. Additionally, the Company has a strong balance sheet at 2.1x leverage, investment grade rating and no real debt maturity until 2022. Additionally, as customers work down inventory in downturns, FLEX’s FCF is counter-cyclical.
Risks / Catalysts / Valuation
As mentioned above, we see nearly $2 of earnings power in FY23 which on just 12x would result in a near double from today. We also can see a case for a higher multiple as FLEX’s mix-shift lowers cyclicality, grows margins, and increases their revenue growth rate. We also would not be surprised to see more restructuring / portfolio realignment, which could come with an increased LT margin and revenue growth guide. Additionally, with a conservative management team, we see a pattern of beats and raises also supporting the multiple.
The greatest risk we see, unsurprisingly, is a strong second Covid wave for disappointing 2H demand. However, we see the demand risk largely localized in their lowest margin segments and much higher-margin auto bouncing off the bottom would help counter. Additionally, we believe the street is under-modelling margins so see significant earnings upside both in the near-term and long-term.
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