Flex Ltd. (FLEX) Earnings Call Transcript & Summary

Hi. Thank you, guys, for joining. My name is Paul Chung, I'm the [ Client ] Emerging Tech Analyst here at JPMorgan. And I'm pleased to have with me the CFO, Paul Lundstrom, here. And before we get started, we're going to have the Safe Harbor?

No, I was just going to say make sure you go to Flex IR site for our Safe Harbor.

Mr. David Rubin as well, thank you. So I guess just to get started, can you provide kind of like a brief overview of the business?

Yes, sure. So first of all, thanks for having us, Paul. I haven't done an in-person investor conference in about 2.5 years, so to be honest, this is a little weird. I'm used to looking at a TV screen to talk to people. But -- so thanks for having us.

Yes. Nice to see people in person.

Yes, finally. So maybe the quick elevator pitch on Flex, who we are and what we do for those unfamiliar with the name. So Flex is a large advanced contract manufacturing company that specializes in that contract manufacturing and also supply chain and logistics. We do -- let's say, we did $26 billion last year. We expect to do about $28 billion this year at the midpoint of our guidance, that would be up about 8%. I think large company, 3 big segments. Our Agility side of the business, we got a Reliability side of the business, which tends to be stickier, longer-term contracts, and then we have a new segment, which we carved out a couple of months ago called NEXTracker. NEXTracker is our solar tracker business. We have a confidential S-1 on file for NEXTracker. Right now, our plan is to ultimately carve that business out. We service a lot of markets from med tech device to automotive, to industrial, to big tech, to renewables. About 1,000 different customers, about 16,000 different suppliers. Has been a challenge managing all those suppliers over the last 18 months, I think as everyone has seen. But I think we've managed quite well through all of that. I think given our scope and scale and the fact that we do supply chain for living, I think we have the tools and the system and the process to manage through the shortages that the whole industry has been dealing with, and I think we've punched above our weight in that regard. Now, you look back over the last couple of years, flat sales during the pandemic year, then up 8% last year. Our expectation is that will be up 8% again this year at the midpoint. Nice earnings growth over the last couple of years. 25% 2 years ago -- we did 27% 2 years ago, 25% last year, and we're expecting double-digit earnings growth again this year. So I would say on balance, I think we've managed through the supply chain crisis and the pandemic with pretty good operating performance and a pretty upbeat future as well.

Right. Great. So we talked to a lot of investors, kind of have to give a refresh on the EMS industry. There's somewhat of a kind of legacy perception issue, but can you talk about how the industry and your business has kind of evolved over time?

Yes. So EMS has evolved a lot over the last 20 or 30 years. You go back and look at the history of the industry, it really started with labor arbitrage in Asia. And it was growing the top line, EMS companies were growing the top line as fast as they could to take advantage of that labor arbitrage and low-cost sourcing, and you saw a very rapid growth in the industry. I think the whole industry's focus was volume at any and all cost, and you saw that in the margin profile of the industry for decades. 2% or 3% op margins was stock standard for the industry, and frankly, stock standard for Flex. And I think over the last few years, you've seen a lot more operating discipline coming from some of the larger players in the space. Flex would be a perfect example of that. Last few years, we've seen, I don't know, since '19, 120 basis points of margin expansion, and that hasn't been just from raising prices. That's from better mix in the business, better operating discipline, not trying to be all things to all people, going after the right types of contracts. And it's -- I think it's become less about pure labor arbitrage and more about capabilities and more sophisticated, more complex manufacturing. Not just printed circuit boards, but more complicated assemblies. A little more IP, a little bit more process, intellectual property, more value-added services, and that has allowed the margin rates to improve. Back to labor arbitrage thing, you look back 15 years ago at the mix of Flex revenue, 50-plus percent -- 56% of Flex revenue came out of Asia. You look at the K we just filed last week, it was 37%. So a 20-point drop in sourcing out of Asia has showed you that it's become more of a regional operating model. And so that's kind of a just broad macro backdrop. My bold thesis on EMS in general is, look at the macro backdrop over the last couple of years and what we've seen with -- and the pressure that we've seen on supply chain resiliency. It goes back to a prior administration and all the saber rattling with trade and sort of antagonism for overseas manufacturing, and I think that created some instability that rolls right into COVID. And after COVID, you have chip shortages. Chip shortages turns into logistics issues and boat stacking up on Long Beach and every other port in the world. And then you have literally war in Eastern Europe, and so that has put such an emphasis on continuity of supply. It's continuity of supply chain. And I think big companies that specialize in that and run that well are going to have an advantage. And so my personal view is that we'll continue to do well over the next several years as there's been such a focus on better managing the supply chain. Because, look, at the end of the day, OEMs, I think, realized, probably got caught a little bit flat-footed with all the shortages and all the other macro disruptions. And if you've got a company that specializes in that, you're going to be an advantage if you're partnered up with them.

So just talk about that advantage. You guys are the experts in logistics, and everybody is going through logistics pain. So are you seeing more discussions kind of accelerated onshoring of manufacturing, and also talk kind of the manufacturing footprint, how you can kind of offer multiple solutions there?

Yes. So it is a real phenomenon. I can give you specific examples. We're shy to talk about specific brands for contractual reasons, we're prohibited from talking too specific on that. But we've got real examples that I was sharing with some other investors earlier this morning, where we have companies that have -- we've always produced for them in Asia, specifically in Malaysia. And now they're asking us to produce in Europe for Europe, producing in Eastern Europe. Produce in North America, in this case, Mexico, for the North American markets. And even though labor costs are lower in Asia than they are in parts of Eastern Europe and Mexico, it still is better for them to produce. Because, one, they want to have product closer to the end customer, and so sort of squeeze down cycle times a little bit. And two, logistics costs are high, and they don't want stuff on the water for 4 to 6 weeks. So it's just better, in some cases, to produce locally. And so we've had a lot of customer inquiries about that. And I think we have incremental work because of our ability to produce just about anywhere in the world.

All right. And then I guess, how the company kind of dealt with the pandemic itself. Can you talk about what changed at Flex as well, and how you manage through the pandemic?

Yes. So sales were flat in the pandemic year. And if you peel the onion on that, our more sensitive to consumer confidence business, Consumer Devices, was down about 24%. But we had growth in other areas. Our Health Solutions business was up 25%. We had growth in the industrial business, and so you add it all up. And what could have been a pretty awful year, and the pandemic sales were flat for us with margin expansion. You move out of that '21 year, which started for us in April of 2020. That was really the COVID year, move into our fiscal year that just ended in March. Sales were up 8%, more margin expansion, nice EPS growth. Looking ahead from '22 to '23, we're expecting 8% top line, again, at the midpoint of our guidance, with more margin expansion. Another 30 basis points is what we're expecting. So I think we managed through the pandemic quite well. I think, again, it's a lot of operating discipline and focusing on what we can control and getting the right mix and the right customer profile. I think it's -- the portfolio is less risky than it was several years ago. I think we've deemphasized the Consumer Devices business, for example. David was just -- David and I were just talking about this earlier this morning, I think 56% of the portfolio was Consumer Devices, what, 10, 15 years ago? And so Consumer Devices today is less than 10%. We did $26 billion last year, and the Consumer Devices business is about $2.5 billion out of that. And so I think by insulating ourselves from some of those more volatile businesses that certainly helped during the pandemic, and we'll continue to do that.

And just to be clear on that margin expansion during the pandemic. A lot of that was mix driven because remember, our Consumer Devices, we took about over $1 billion in from 2019 through to 2020. And so it wasn't that we were getting some special pricing or anything like the semi companies might be getting. But again, that was mix driven and then the answer is productivity.

Okay. And then as we think about kind of post-pandemic life, some of these supply chain issues are not going to moderate quickly. So do you see any kind of permanent impacts on the EMS industry? Do you have to, like, operate with higher inventory levels, et cetera?

I think it's too early to tell. I mean, you guys are probably well aware that everybody is looking at inventory levels that are elevated lately. Everybody is waiting on the golden screw or the golden chip, and so you have 99% of the bill of materials sitting, waiting for that one critical component, and you have it waiting because you know there's demand. And the backlog for our end customers are quite high, as high as we've seen in a long time. And so you want to have that inventory so you can drop in the chip and produce as soon as it becomes available. And so everybody has been carrying elevated inventory and look, I don't like it, but it's sort of the nature of the beast at the moment. Structurally, what's going to happen coming out of the pandemic and out of the chip shortage we're dealing with right now, hard to say. Permanently elevated inventory. If that's going to be a thing, I think we're going to have to have some conversations with customers about that because this isn't a huge margin business. I don't want to be carrying tons of working capital that sort of would be disruptive to the business model. The way I would see it going down, if it is going to be a thing for the whole industry to carry more inventory, I would expect OEMs to probably carry a little bit more buffer stock themselves in finished goods. Maybe the EMS companies carry a little bit more inventory. But I said before, we've got 16,000 suppliers. I don't see a path where they wouldn't be carrying a little bit more inventory as well. So I think that would be -- it would be shared burden, not all on us. That's just the only way it would -- the only way it would work.

Yes. And then just expand on kind of what your current inventory situation is, and when that harvest you expect to kind of come through? And then some of the working capital requirements there, are you seeing more customer deposits or anything that helps on the cash flow?

Great. I mean, for sure, on the customer deposit side, we've seen inventory up significantly. I think it was up 67% year-on-year. That's a fairly big number. But more than half of that has been offset by higher working capital advances from our customers. You probably heard us talk on the earnings call, working capital advances are up about $1 billion. Deferred revenue is up a little bit as well. So you add those 2 together, it's about $1.2 billion of working capital support for the inventory growth, which is -- that's helpful. Again, back to the permanent effects. I don't see a path where this doesn't unwind here over the next several quarters. It's not going to happen by June, I can tell you that with supreme confidence. We're not getting that much traction with chips. It's going to be a few quarters. But on inventory, the nature of the business is we buy what our customer demand forecasts would suggest we buy. And if we're -- if you end up sitting on that inventory for a protracted amount of time, contractually, you start to get either working capital carrying charges, or in some cases, the customer has to take delivery of the inventory. So I feel between working capital advances that we're getting in support for that higher inventory from our OEM customers or the ability to push that back, ultimately, I feel okay. I don't love it, but I feel okay.

Okay. Let's talk about the pricing environment. The firm has definitely been more disciplined on price over the past couple of years with what I've seen. You've seen that benefit on margins, and it's kind of lifted boats for everybody in the industry. So talk about the pricing today and how that trends?

So I agree with your comment on Revathi, a lot more operating discipline. She is very focused on having our commercial teams going after the right mix, the right customers, the right type of work where we believe that we can add value and where we can make money. Of course, we're disciplined on price. We get price where we can. But our margin expansion has definitely not been driven by price. I just want to be super clear with the investor community on that one. We are not a chip company where you see all sorts of stories about, hey, we're going to give you a 50% price bump because I know that supply is massively constrained and demand is huge. We don't have the ability to do that. It's just -- it's not our operating model. That is -- that's a chip company thing, not an EMS contract manufacturing thing. Again, we get price where we can. If you look back at the 120 basis points of margin expansion, we saw, despite the pandemic and all the other shocks, it's been driven by mix. You look at the faster-growing elements of our portfolio. They happen to be higher-margin business. Things like med tech has been good. Our Lifestyle business also strong margins, and we see great growth there. Lifestyle was up 14% last year. That's fantastic. So it's been driven by mix. It's been driven by better operating discipline. Of course, we get price where we can, but I'll say it's -- we are far from "over earning" like you could maybe argue the chip companies are. That's not our model at all.

Got you. And then you just touched on the margin trends going on. What kind of gives you the confidence for the full year kind of margin target?

Yes. So last year, we did 4.5% OP margin. Our -- the midpoint of our guidance right now is 4.8%, so that would be another 30 basis points. Kind of along that same trajectory that you've been seeing. That will largely be driven by mix. If you look at the Agility side of the business versus the Reliability side of the business, Reliability, which has the Health Solutions business, has the Automotive business and has the Industrial business. Those will grow at a quicker clip than what we're going to see on the Agility side, which is a lower margin business. But managing mix isn't just a segment phenomenon. It's not just Agility versus Reliability. What you've seen over the last couple of years is really nice margin expansion out of the Agility side of the business as well. So managing mix amongst the 2 seconds, but also managing your customer profile and mix within the business units beneath is going to be a big part of it. And then just going forward, of course, we're a big manufacturing company with 100-plus facilities around the world. Are there ways to do a little bit more with a little bit less and then continually optimize the footprint and do more with robotics and automation? Absolutely, we continue to invest in productivity. And can you get a little bit of margin juice out of that over the next couple of years? Yes, we think we can. That's just part of the DNA.

Okay. Can we dig a little bit deeper into some of the verticals like the secular growth opportunities you're indexed to and that also comes with some nice margin upside there, but where are you seeing kind of some of the bigger opportunities across your portfolio and some of these emerging trends you saw or you laid out at the Analyst Day?

Yes. So the 3 big ones that we talked about at the Investor Day a couple of months back. One, growth in cloud. We are a bull on continued growth in cloud. And we've got a couple of pieces of the business that are indexed to that. One is within our CEC business that does specific to rack and server support. The other piece is the acquisition that we made back in December, Anord Mardix, was a transaction that we announced Q4 of the calendar year last year. And that does power support for the hyperscalers and we've got high expectations for great growth out of that business. And so I think we've got a nice connection to the data center and the continued build-out of data centers. We believe that's going to continue. I know there's lots of talk about economy and what's often and what doesn't. My personal view is that cloud will continue to grow.

Okay.

So that was one. Other one we talked about was on the automotive side, next-gen mobility, and I know you're an expert in that one. Continued growth in EV and then ADAS, just as the cockpit gets more and more sophisticated as we continue to progress towards automation, that next-gen mobility is going to be a tailwind for Flex. We like where we are there. We're continuing to win share. I would say, both at a brand level, and geographically, we're pretty well balanced. But we're upbeat on how we're playing in the automotive space, and that could be a nice top line expander for us over the next few years. And then the other one we talked about at the Investor Day was Health Solutions. We continue to see OEMs outsourcing more of their portfolio to contract manufacturing companies. I think the chip shortage and all the supply chain disruptions that we've seen over the last couple of years have just reinforced the importance of supply chain resiliency. And particularly in med tech devices, I think we're going to continue to see that trend. That should be good. And if you look at how we're winning and where we're ramping in-house solutions, we have ramps coming online that give us the confidence to project double-digit growth on the top line for Health Solutions. So those are the 3 that we spent time talking about at the Investor Day. There's a number of others that we should continue to talk more about at events like this. The one I'll just share with you right now that I'm bullish on continues to be the renewable energy space. We have the NEXTracker business, which can't get into heaps of detail on NEXTracker because we've got a confidential S-1 on file. But I can talk about the macro backdrop for the space. And I'll add that we have a fairly significant piece of our industrial business today, has a concentration of solar type products and renewable energy. And looking at the ramps that we see in that industrial business, we just talked about one -- actually, I think it was Enphase that did a press release on a couple of weeks back. We've got some nice incremental work for that in the industrial business. That's going to be a tailwind over the next couple of years. And so I'm quite upbeat on that space as well, and we'll probably talk more about that over the coming months and quarters, but yes, there's a lot to like.

And then just to follow up on the solar tracking space. Can you give us an update on what's going on with your competitor and what that does for you?

Should you talk about the company that starts with A? Is that what you think?

Yes.

I'd rather not talk too much specifically about the competitor. I did get a few investor questions this morning just about what's happening politically in the space. And the churn in the industry right now is there are some, I guess, you could say, conflicting priorities between the Department of Energy and the Department of Commerce. Department of Commerce right now is investigating accusations of dumping and duties circumvention on solar panels coming out of Southeast Asia. And I think that will resolve itself over the coming months. It has to resolve itself. Policymakers just need to get their priorities sorted, and I think they will. I think we're expecting resolution on that in August, and so that could be a little blippy over the next couple of months. But the macro backdrop on that space is incredible. I mean, well, let's just look at some of the facts on solar. It's a ridiculously large opportunity over the next many years for companies like NEXTracker and also core Flex because of what I said about the industrial portfolio. Just some stats on those markets. Last year, in the U.S., electricity generation specifically from solar was 3% or 4%. Goals right now are 30% by 2030, 40% by 2035. So you're talking 10x growth, huge growth in renewables. And if you look at the build-out of incremental electricity generation capabilities worldwide, expectations are that half of that is going to come from solar. Like, okay, that's a big number. Is there any facts behind that? Well, here's the U.S. Last year, new capacity installations, 46% came from solar, so that ties right into that about half. So I'm really upbeat on the space. I think there's all sorts of macro tailwinds. So I think we feel good about the long term. Are you going to have some periodic blips like right now with DOC? Probably. But long term, it just doesn't matter.

Let's circle back to the supply chain. From where you sit today, is it getting better? Is it getting worse? How are you managing kind of lockdowns in Shanghai? How that gets to...

Yes. So Shanghai, that's a fun one. So maybe that first, and then I'll talk more broadly about the supply chain. So on Shanghai, the good news with Shanghai is Shanghai was already shut down for a month when we gave our guidance, and so we sort of knew we were going to at least take 1 of 3 months out of the cycle for our first quarter here, which started in April. Our expectation was that the shutdown would continue for another couple of weeks. Here we are in month 2. I think expectations that maybe things come back online in early June. In terms of specific impact to Flex, it's a knit, and it was all contemplated in our guidance. If you look at how much we actually do in Shanghai, we got 170,000 employees, about 1,500 are in Shanghai. It doesn't really matter. Does it have effects on other parts of the supply chain? Are you going to continue to have shortages because of other facilities that are closed down? Yes, probably. But you know what, we've been dealing with that for the last 2 years. Nothing new here. And I would say what was more disruptive was what we saw in Malaysia a year ago. We had much, a much larger facilities that were affected. That was a full country shut down for the better part of 6 weeks. So Shanghai specifically, not too, too concerned about it. I don't love it, but it's sort of the new normal. We're having disruptions every quarter, and we just deal with it. And again, I think relative to other things we've seen, it's -- don't love it, but not -- it's not the end of the world. More broadly, in terms of component constraints. So our Q4 closed in March. When we gave Q4 guidance in January, we were a little concerned about continuing power shortages. It continued to be an issue through the quarter, but it was not as bad as what we thought. So we cleared more hardware than what we had anticipated going into that -- into our fourth quarter, which again, ended in March. I would say we've continued to clear at that same rate as we've moved through our Q1 here. So feel okay about how we're doing in terms of chip shortages and just general component shortages. I wouldn't say not significantly incrementally positive, definitely not incrementally negative. We're kind of treading water like we did a quarter ago. So I would say overall, given what we've been dealing with, that's probably a slightly more upbeat tone.

Okay. That's good. And then just on component inflation. And I mean, for the most part, you guys are kind of passing on that cost to the customer. If you could talk about those dynamics?

Yes. So back to the chip thing. So we have had inflation before, everybody is seeing that. It affects companies like Flex as well, but in different ways than either the consumer or the chip companies. On one hand, you have the consumer who's paying for it with a smaller bottom line. On the other hand, you have the chip companies who are getting benefits from it through raising prices, and that's dropping into better margins. Flex is right in the middle. So I would say, from a profit dollar perspective, not really worried about it. The way it works, the mechanism is, it's largely a cost-plus contracting environment, in some cases, cost for cost. And so if we have -- if you have an individual component that you get a large price increase for, we will immediately go back to our end customer and claim that back to get recovery. So we're not eating it. Now, are we always marking it up? No, not always. And you've heard some other EMS companies talk about that. The more episodic price inflation is passed through direct, not necessarily with a markup, and so that could have an effect on margin percent. But in terms of margin dollars, we continue to feel quite confident with what we've laid out here for 2023. We're passing through inflation costs. I think we're fairly well insulated from that, which is good.

And then just talk about kind of -- if we kind of enter into some global economic slowdown, how is the firm kind of positioned? You kind of take share from some of these smaller players? Just how has the business trended during kind of rough waters historically, and how you think it does now?

Well, in terms of taking share from smaller players, that sounds good. We'll just have to continue to operate in a disciplined fashion. We're not chasing volume at all costs. If we can get incremental work at good margins, we'll take it. In terms of things potentially slowing down, we've gotten that question a lot lately. And let me just kind of take it top to bottom just through our business unit structure, just to give you a perspective. Because you can't just take a high-level view, you really have to peel the onion a little bit. And so if I start with the Agility segment, and specifically CEC. So CEC, Communications Enterprise Compute. That's more the techy side, I guess you could say. Thinking about 2 macro phenomena that should continue to be a tailwind in CEC, I would say, one, continued rollout in 5G. I think if the economy softens, I think you'll see -- still see spending on advancing 5G. The other area that we're upbeat on is cloud. You look at the hyperscalers and you look at the CapEx expectations for those hyperscalers. Whether the economy is up or down, I do think you'll continue to see build-out in cloud. So that's probably 2 tailwinds for the CEC side of the business. Could enterprise be a little soft if corporates back off on spending? Yes, they could. I don't think anyone is completely immune to that. But I think there's some nice tailwinds in the CEC side. Probably the 2 businesses most susceptible to a softening economy, specifically because of things like consumer confidence, our Consumer Devices business, which, as I mentioned before, we have significantly de-emphasized that part of our business for a number of years. Last year, it was $2.5 billion, so it's less than 10% of Flex. The Consumer Devices business in the pandemic year, which was awful, was down 24%. Could it be down that magnitude again? I guess it could, but that would -- that's -- I mean, pandemic, everything just shut off. So I'm not sure it would be that negative. The Lifestyle business also within the Agility segment, that was about a $4.4 billion business last year. That one is affected by consumer confidence. We're running all sorts of scenarios on that just to make sure that we're adequately prepared. But if I look at the Lifestyle business, like you'd look at lasagna, there's lots of layers of that portfolio with a number of new ramps. And so if you're going from -- if the base plan for a new product ramp was to go from $0 to $200 million in a weak economy, does it still go from 0 to something? Probably. Maybe it's not $200 million, maybe it's $100 million, but it's still growth, and we have been taking share in that Lifestyle business. So although I think it would be reckless to say it's immune, there's potential offsets as we continue to gain share. Again, so the Consumer Devices and Lifestyle probably the most susceptible to things softening up. On the Reliability side, again, it would be reckless to say it's immune, but there are reasons why I'm a little more upbeat on the Reliability side. Starting with automotive. Automotive, look, channel inventory is really, really low. And it has -- it continues to get worse in terms of lower inventory levels in the U.S. David was just telling me this morning, 21 days is inventory on dealer lot in the U.S. That's down from 22 the month before, so it got lower. And compared to historical norms, inventory on lot's about 60 days. So there's going to have to be some level of replenishment, but that's just the U.S. market. What about abroad? You look in Europe, it's a little bit different business model. It's not cars sitting on lots. It tends to be more of an order deliver model, and backlog is as high as it's been in a very long time. So high now, that you've got auto OEMs who are turning customers away saying, look, I can't put you on the list right now because I'm worried about a model year change. So really high backlog. So that needs to work itself out over the next several quarters. And so could automotive be a short-term problem? I think probably not. Could it be a medium or longer-term problem if things are worse? Yes, but I think we would see that coming. Other businesses in Reliability. We have an industrial portfolio. That's the biggest business within Reliability. A wide range of products. We do some casino gaming kiosk stuff, casinos and then things like lottery tickets tend to do better in a soft economy, for whatever reason. And then capital goods like robotics and process automation work. Look, if the big industrial companies see a softening company, they tend to squeeze on CapEx. That could affect that business a little bit. But as I mentioned before, one of the bigger businesses within industrial is renewable energy. And we see new product ramps and continued growth in that solar space, and I think that helps to buoy the industrial business a bit despite what might happen with the economy. And then Health Solutions, just calling out that one last, I guess, and on a very positive note. We're expecting double-digit growth from Health Solutions. Health Solutions has a number of ramps. I think health care is one of those things that if you're treating diabetes, it doesn't really matter. If interest rates are high or low, you need to do it. Yes. So...

Okay. So we got like 1.5 minute left, so just talk about kind of your cap allocation. You did -- ramped up some share buybacks here. What's that going to trend like throughout the year, and also your acquisitions and dividends?

Yes. So maybe starting with dividends. I would say it's not short term in the cards here to establish a dividend policy, but we are certainly not opposed to capital return. We've done that via share buyback. You saw our buyback step up significantly last year. I think we just did under $700 million, which was 3x the average of the 3 years prior. So we definitely put our money where our mouth is in terms of the value we think that this business can create. So I would say, of our capital allocation priorities, that's probably the highest right now, buy back. M&A, we don't want to slam the door on it. But right now, I think the -- probably the lower risk, better investment for us is to buy back our own stock, and we're going to continue to press on that.

Okay. Great. So I think we'll call it a wrap here. And thank you so much for your time. Appreciate it.

Happy to do it, Paul.

Yes.

Nice to see you. Thanks.