Sanmina Corporation ($SANM)

My name is Ruplu Barataria and I'm with the IT, hardware and electronics manufacturing services equity research team at Bank of America. Today, we're honored to have Jon Foust, the CFO of Sanmina Corporation. Jon has been with Sanmina since 2023, but he has over 20 years of experience with another company that we cover HP and various branches of HP. So he's got lots of industry experience, and we've got a lot to talk about. So Jon, thanks for coming.

Yes. Thanks for having me, Ruplu. Good to see you as always.

All right. Great. So I want to talk about -- I want to start with something that's on everybody's minds, and that is ZT Systems. So if I remember from the last earnings call, you showed us a slide that showed the evolution of ZT Systems in 3 stages. So can you kind of remind us of that, where does ZT stand right now in terms of qualification and testing and how do you see its evolution progressing over the next quarter or 2 quarters?

Yes, absolutely. So whenever you do a deal like the deal with ZT or an acquisition and -- it's very important to have a well-thought out strategy or just a plan effectively of how you make the investment thesis successful, right? What you want to do with the business exactly. So to your point, what we tried to do on our last earnings call is kind of lay out that plan in very simplistic terms, like very high-level terms, just to give investors and sell side, buy side, a better idea of like where we are at in the process. And so when we first closed the deal at the end of October last year, we just wanted to do the initial integration work and so forth. But what we were also doing is taking a bit of a risk continuing to make investments in the business because we knew that there were certain elements of ZT that we're going to transition over time. But ZT was making a lot of investments when they're a stand-alone company, again, when they're part of AMD, and we wanted to continue with that. Now that was kind of the first phase, the first things that we needed to do. The second phase was all about winning business, maintaining the business that ZT had across all 3 lines of business. So that's general purpose compute, CPU-based platforms, storage and then also accelerated compute, the GPU-based platforms. But we had to go win that business. And as we announced on our last earnings call, like we have won that business, both preproduction and production stage business, which is great. Now to the question that you're asking, what we're working on right now is we're working through the preproduction phase, and we're starting to kind of lock in what production will look like. Now we've got a pretty good idea from the customers already what the forecast is going to look like when we get into production at the end of this calendar year and into next year, but there's still a lot that we have to learn in preproduction, but everything is very much on track, and we're very excited about it. I mean, when I think back to that plan that we said, we've been executing very well to that. Everything that we said since day 1 and so we just want to continue to do that. And right now, the stage is do the preproduction testing. So we're getting units to AMD, for example, to customers and so forth. We're learning a lot on how to produce and manufacture the products. And then that will help to finalize the eventual production schedule. And that's when we'll come out with more details from a guidance perspective, like the scale, the revenue, the profitability of the business. But right now, we're right where we expected to be in that overall plan that I mentioned.

Got it. You mentioned different buckets and different things that ZT does. Can you elaborate a little bit? Talk to us about what ZT does in terms of accelerated racks, non-accelerated racks and how do you -- how should investors think about overall long-term trends in these businesses and revenue growth?

Yes. So ZT historically, the company has been around for 30 years. I'd say the last 15 years, they were focused on the data center business and as an ODM player. So they were a true ODM, so competing with the large Taiwanese ODMs, for example, across those 3 lines of business that I mentioned. So servers, CPUs, servers, storage and accelerated compute and they were fantastic at it. Now those are all lines of business that we wanted to get into, Sanmina because if you think about the core Sanmina business or the legacy business, when it comes to what we were calling cloud infrastructure, we were predominantly focused on data center networking. So this ZT deal helped to expand our TAM. It got us back into server integration work, storage. When I say server, both CPU and GPU business, so we are excited to expand into that, and we want to maintain that business. But it was a true expansion of our TAM at the end of the day because Sanmina had gotten out of those businesses. Now what ZT always was focused on as an ODM was just the final system integration and test. So really like L10 to L12 manufacturing, they didn't do any subassemblies or anything below that level. Now that's what Sanmina brings to the table, and that's what makes this deal and this transaction synergistic for us. We want to make sure we want to win business where ZT can continue to do what they've done very, very well in the past, but then complement it with what Sanmina can do because we can do board fabrication, we can do rack fabrication. A lot of things that ZT wasn't done. But first things first, back to the plan that I mentioned about achieving the investment thesis. It was winning business, maintaining the business with ZT had with their legacy customers, win more customers with what they do well, and then over time, I introduced some of the capabilities that Sanmina brings to the table with vertical integration. But to answer your question directly, maintains a in all 3 lines of business.

Got it. Can you remind investors what you've telegraphed in terms of revenues for ZT for this fiscal year? How much revenue have they generated so far? And what should investors be thinking of for the rest of the year? And if you can segment that between AI-related and non-GPU related?

Sure. So we announced the deal May 19 of last year. It's almost a year ago exactly. And at the time, we said a couple of things. One, we said when we were closing -- when we expected to close the deal, which happened at the end of October, that same year, we expected the revenue run rate for total ZT to be in the $5 billion to $6 billion range. And that's held true. If you think about the full year, fiscal year '26 guide that we gave in our last earnings call, the ZT guy that has you right in the middle right? Now of course, there's a range. So it could be towards the higher end of the range or a little bit below the midpoint, but solidly within that 5% to 6%. And so we had mentioned that all the way back on May 19 before we even closed the deal. And this is why I say Ruplu earlier that we're very much on track on our execution of our plan for ZT. What we also said back on May 19, a year ago was that we expected to double Sanmina the size of the company, speaking about revenue within 3 years. And so at the time, core Sanmina was about $8 billion, so that applied a $16 billion number, but we said within 3 years. Fast forward to when we closed the deal, we accelerated that and said, hey, we expect to do that within 2 years. So we brought that forward by a year, which implies our fiscal year '27, right, which is coming up soon. And then on our most recent earnings call, we said $16 billion plus. Now that we've got customers lined up, we've got a better point of view on the production schedule, still preliminary, albeit it's not really a formal guide, but we said $16 billion plus -- and Jure made the comment on the call about becoming increasingly confident, right, about the business, and that's because we had a plan, and we've been executing 1 step at a time. And so it's been going well, and we just want to continue to execute to that plan.

Got it. Got it. That makes sense. I'm going to come back to the revenue streams in a bit, but let's talk about manufacturing facilities. So I think you bought 3 facilities when you bought ZT Systems. Can you give us an overview of how those facilities are trending? Are they set for building data center racks? Do you have enough power? And how should we think about the production capacity of these facilities?

Yes. So it was facilities, 3 plants that we acquired as a part of the ZT deal. So the primary headquarter location plant is in Secokus, New Jersey, just outside of Manhattan, there's another facility here in the States, in Georgetown, Texas, just north of Boston and then a third 1 in the Netherlands. And all of them are capable of producing business already across those 3 lines of business that ZT was in and state-of-the-art facilities. Now what we've been doing, and this started even before we did the deal. And again, over the past couple of years, even before we closed, is -- there's been investments made in those facilities to retrofit them effectively for the next generation of accelerated compute, because the power demand is incrementally like massively larger, right? And that's one thing as we were talking with customers, they want to understand the power road map that you have and you need to have those agreements in place with the local governments, the cities, municipalities and such and we've got that. We had those agreements in place. And that's what was really attracted to us about the assets that we picked up as a part of this deal is that you not only had plans executing at scale across those 3 lines of business. But for the long term, you had agreements in place for power. You also have to retrofit the test cells for liquid cooling. So you have to have large chillers in the facilities and so forth. So we've done that. We had to keep that pace and that was going to be important to win the next generation of business. So those investments have largely been made now. I mean there's more money to spend over time as power comes in, but we've retrofitted that, so we're prepared. And so that was critically important, right? And now as we're in the preproduction phase of the next generation, we're already leveraging those capabilities, right, to build these products and we're learning more every single day in the preproduction phase. I'm talking engineering validation, design validation and each customer has a slightly different schedule, different configurations of the product. So you learn a lot, and that's important in our business is to be involved in that stage to make sure you really learn what it takes to build these products.

Got it. You've guided for strong revenue growth, I mean, $16 billion plus by fiscal '27. But the question that I keep getting from clients is, do you have enough capacity to meet that demand? And hopefully, as you grow with AMD, you get more rack orders. Do you have enough facilities to satisfy the demand for the revenue growth that you're going to see.

We do. I mean, we've definitely got the capacity now to do the $16 billion plus. And we'll learn more over time, like we've got estimates right now as we've been learning through that preproduction phase on what it takes to build the product because then you start to estimate how many racks can you build in a given week, month, quarter, right? And it all depends right now when you're just doing preproduction, not like the full-scale unit, production level, silicon and so forth. You've got estimates on how long, not just to integrate it, but to test it because you got to ship it as a complete turnkey product to the customers to put into their data centers. So we'll learn more about that. But we've got the capacity in place. Now longer term, the Sanmina has a very large footprint. Now not all of our facilities around the world have been retrofitted, have like the power or the liquid cooling test cells, for example, to do accelerated compute. But we certainly do for storage for example, or CPU-based general-purpose compute, pick your term there. So we've got different levers that we could pull essentially if we wanted to move business. So we're very successful with accelerated compute with customers and we need more capacity, we could leverage the ZT facilities that are specialized for that. and then potentially move other business elsewhere or bring up new plants.

Got it. So you mentioned this non-GPU non-accelerated business. How do you think about that market? And what are the pros and cons of focusing on that business?

I mean the news over the last, I don't know, what is it, 3, 4 months, right, whether it's from AMD or I know HPE, prior company of mine announced recently this week, general-purpose server, CPU-based platforms are doing extremely well right now. And that is one of the lines of business that ZT is in. Now for us, as a part of that plan that I mentioned earlier, we are very focused on making sure the transition of accelerated compute was successful, but that doesn't mean that we're ignoring the CPU-based business, right? You just have to make sure that you don't have too many priorities at one time, because if you start to slip with these customers, especially hyperscalers that want product at scale, they don't want the issues, you don't want to get yourself overcommitted. But that is an interesting business to us. So our strategy and approach as a part of that plan was maintain the legacy customers that ZT had with the programs they had, convert to the next generation of accelerated compute and then expand from there. Now we've talked a lot externally about vertical integration, right, doing more things with the rack because of Sanmina's capabilities, right, like below L10, for example, but it is an expand like the program set that we have, too. So the CPU servers, right, and even storage products. So we are interested in that, and we do have like a team in place that focuses on that. But you got to take 1 step at a time, and then you can win more programs, especially with the large customers.

Got it. Maybe I want to transition into margins now. So talk to us about how you see ZT Systems margins trending over time. And if you can address 2 things. One is consignment versus not consignment, how does that impact things? And then just in terms of the AI revenues versus non-accelerated revenues, how does that mix impact margins?

Yes. So the operating model that the customers choose, so consignment or non-consignments, which really just means that we never take financial control of certain components, which means in our business, we don't recognize revenue on it. like that's all dependent on customer, but you do see it across all 3 lines of those businesses, right? Some customers very much prefer like a buy-sell model where they control certain components, whether it's the CPUs, the GPUs, memory, et cetera, and then we wouldn't rev rec that. But we're fine to work in any of those models, right? It's for me, from a CFO perspective or from a financial perspective, the true economics is how much profit are you making per rec or per unit that you're building and making sure that the ROIC is good on that front. Now in the short term, with the mix of the business that we have right now, we've said that the margin profile is similar to core Sanmina. And you've seen that play out. It's actually been a little bit more favorable than that in our Q1 and Q2 results and even our guide for the back half. Core Sanmina exited fiscal year '25 at a 6% operating margin. So we're already there it is core Sanmina. If you look at Q1 and Q2, we've done better than that right, a little bit better in Q1, quite a bit better in Q2. And our guide for the second half is even better. So ZT has done well from a margin perspective. But the core Sanmina business is continuing to make progress as well. So that's our best estimate for right now. Now we haven't formally guided FY '27 yet because we have to lock down the production schedule with the customers. Also the final mix of the customers, that will dictate the operating model, so that could change the profile. But our best guess right now, and we've been saying this since day 1, when we quoted the $16 billion for revenue is there'll be a good mix of consignment in their similar profiles for now for -- around that semen profile, I think like 6%. But over time, if we're successful with vertical integration, that wouldn't be more revenue throughput that would just be profit dollars, so that should drive accretion.

Got it. last quarter came in better than expected for ZT. I think you also ZT used to do some legacy accelerators as well, both for NVIDIA as well as the earlier versions of AMD's accelerators. Talk to us about that. I mean, is that a business that you would like to be still in? And how do you see that trending?

Yes. So in Q2, we effective -- we didn't have almost any, I think was close to 0, like legacy accelerated compute platform business NVIDIA-based business. That had gone to 0, which we always knew was going to happen because of the nature of the transaction that AMD did. What we did have that we were very pleased with was current generation like new business for us, like AMD platform business, for accelerated compute. And we executed very well on that front and got some incremental, delivered strong demand, too. Now we always expected that to be batchy business for us. The real opportunity for us is the next generation of accelerated compute. And the reason being is, by the time we did the ZT deal, manufacturing partners for the current generation, right, the accelerated compute was already done. But the dynamic that we saw in Q2 was some customers wanted to test us out, test out ZT. Can we build a different platform of product, learn how to do business? And that was a very important precursor to winning the next generation of accelerated compute prove that we can do it today. And when we had guided the full year, we expected -- we had some of that demand in place. We expected it to happen between Q2, Q3, maybe even a little bit before in Q4 and that was because of when we thought certain components and supply was going to become available. But once more supply became available, this is the strong execution point. The customers wanted that product immediately and ZT did a fantastic job building that product, shipping it. So you saw the results that we had, which was essentially an acceleration. So our full year guidance didn't change, like our outlook is still consistent, but the timing changed because of the strong execution. And we got some more demand, too. So we'll see if some ore comes in. But right now, we're really laser-focused on getting prepared for the next generation to make sure that, that goes well.

Got it. So building racks as a working capital-intensive business, right? And as you build more and more racks into inventory, how should investors think about working capital, inventory and free cash flow?

Yes. So you're absolutely right. So over time, our working capital will build. The dynamic that we've seen in the first 2 quarters with ZT though, was that legacy business kind of coming down, right? Because we knew that, that dynamic was going to be happening. So we've been generating a lot of cash, which is great. We've been preserving that cash. If you look at core Sanmina, somewhere around $600 million per cash in any given quarter when we would exit. Now we're $1.5 billion in that range. So we've been generating a lot, and that is to get prepared for the eventual working capital build. I expect that to happen towards the end of the calendar year. Some of it will start here even in Q3 and into Q4, but depending on the operating model, like how much is consignment versus not because of its consignment, then we don't have to go pay for those materials. We receive them physically. So that will play in. But I do expect working capital to build. So what I've talked about externally is I think about it from like a leverage ratio perspective and Sanmina had the best balance sheet by far in the industry prior to doing this deal and even post doing the deal, we're right in the range of our peers and competitors. But I set a target range of 1 to 2x net. And we've been well below that so far. I do think we'll come into that range as we get into the back half of the year. And depending on the operating model, it could even go a little bit above it, say, like into next year, we'll see. It depends on that final production schedule. But -- but that's all been part of the plan. That's why we set up the capital structure that we did, not only to purchase the assets, but to get prepared and to have the balance sheet and dry powder to support the growth of the business.

Got it. Okay. That makes sense. I do want to touch the rest of the business. But before we get to that, are there any risk factors to ZT revenues for this year that investors should keep in mind?

For this fiscal year, I mean, there's always risk, right? But if I think about the ZT the big risk factors was one of the big ones was were we going to win in business? Were we going to stay in the accelerated compute business and win the next generation? And that's what we talked about in the last earnings call that we've essentially kind of cross the chasm from that regard. But there's still a lot of work to be done, right? We're in this preproduction phase and we need to execute. So the biggest risk right now is not executing. And that's why we're so focused on like let's make sure that we execute well. So when customers want certain preproduction racks, whether it's EVT, engineering validation or design validation whatever component mix or configuration changes that they want, like we need to execute well on that because that's really what we're doing this fiscal year for us, all right? Then as we get into FY '27, that's when the production scale will happen. So we've got to get prepared for that. So we're -- but for this fiscal year, it's really just kind of executing well in the preproduction, continuing to win customers kind of lock down that demand. And the same thing on our core business, but that's normal for manufacturing you have to execute. Otherwise customers will go elsewhere.

So let's move on to the rest of the business because if we think about legacy Sanmina, you have a very good footprint in optical communications. So talk to us about how the communications market is trending and how do you see Sanmina position in this?

Yes. Communication, I mean, what the segment or what we call it is communication networks and cloud infrastructure. So just talking core Sanmina, legacy Sanmina, that part of the business has done extremely well. I mean it's 7 quarters in a row now that we've been growing around 20%, 20-plus percent, and that includes the optical part of the business. And the reality is that we could be doing even better there. There's a lot of demand, but it's constrained, right? So on the cloud infrastructure side, whether it's -- if you think like data center networking, it's different chips and so forth, memory, things that come into play. On the optical side, it's lasers that you need to do the manufacturing, but the demand is there. And we expect that to continue. But the core business overall, and that's been a big reason why, like last fiscal year, the core business grew high single digits. We've guided this year that it will be the same. It's a little too early to say like we haven't guided FY '27. But on our last earnings call, we said that we don't expect that dynamic to change anytime soon. And we'll see what happens with the supply environment. But if it stays constrained, similar type of profile, but when that eases up, we think we could do even better. And on top of that, Ruplu, we're always looking to win incremental business, take business, larger share from customers. So hopefully, we can do that, too.

Yes. I want to address some other end markets. But before I do that, maybe I'm going to jump to the capital allocation question. As you see working capital needs going up, how should we think about your allocation of capital to CapEx any M&A that could be relevant? And how should investors think about returns?

Yes. So the capital allocation strategy for us has been very consistent. It's all about driving growth, right? That's what we want to do at the end of the day. Now we always look at it from an ROI perspective. So I'm always balancing the ROI of paying down debt, doing share repurchases, things of that nature. But we're heavily indexed to how do we preserve the dry powder to drive growth. And that's why you've seen our cash balance grow over time because we know that we're going to need some of that cash to drive the growth, depending on the operating model of the future. But that doesn't mean that we don't continue the pipeline going from an M&A perspective. We're always looking for opportunities to grow and expand our business. And we might have -- we might do different acquisitions on that front, whether it's bringing in engineering talent or bringing in new capabilities, automation, things of that nature, not just for ZT, but for the core business, too. And that's why it's important that we have this strong balance sheet. But the balance to that is, I'm always looking at that leverage ratio and making sure that we stay within the right range, and we don't get overlevered by any means. So we'll continue to do that. We'll be opportunistic. I mean if you go back to after our Q1 results, the stock was down quite a bit based on the market reaction. So we did do some share repurchases to offset the dilution of the shares that we granted to AMD as a part of the ZT deal. But but that was because the ROI was just so attractive not to pass that up. But now it's all about driving growth.

Got it. Sanmina also has another unique business, which is the defense business, and SCI has been a very steady contributor to revenues and cash flows. What's the long-term plan for that business? And how is that business trending?

Yes. Aerospace and defense has been a great business for us, and we've got a mix of traditional like EMS contract manufacturing work, but we do have our own products and IP in that business, and it has been growing and it's accretive to business. If you look at the overall profile. So it's definitely something that we want to grow and invest in. And based on all the conflict in the world, which is unfortunate, like there's no shortage of demand there. And there's new players coming into the market, not just the legacy primes that everybody knows about the large players, but new companies that are coming in, too, that we've been targeting. So more to come when we guide FY '27, but that has been an area of focus for us, putting capacity in place, winning new programs with new customers. So we think that, that will be an attractive end market for us. maybe not quite the same scale as AI in these days, but it's a good business to be in.

Got it. How about the industrial end markets, what's happening in there?

Industrial, too, is we're starting to see that come back for us. If you go back a couple of years, all the end markets that we are playing in, we're working through inventory absorption, right? So a lot in the channel and so forth. Industrial is kind of similar. So whether you think about like semi-cap equipment, like that's starting to get better, so the inventory profile is getting better. And if you look at like our core Sanmina business, when we talk about the different segments, that was in Q1, industrial, medical, aerospace and defense -- there's a bit of a headwind, down like 3% year-over-year. It was flat in -- but as you look at the back half, it's going to return back to growth, and part of that is the improvements that we're seeing in the industrial space. And that's across both like semi cap equipment, but then other areas, too, things like police handsets, radio handsets, cameras, equipment like that for security purposes, that's been doing quite well already. but we expect that to get better. Again, maybe not the same growth profile of some other end markets, but still a good business to be in.

Got it. So you've got about 2 minutes left. And I want you to leave investors with what you think the market is missing about Sanmina's story? And one question I keep getting from clients, I want you to address this as well. the AI rack building space is a very crowded space. I mean there are lots of companies, EMS, ODM who can do this. How do you see Sanmina and ZT Systems positioned in this market. What are some of the unique things that ZT brings that will let you compete in this market against those players?

Yes. Let me start with the CT side first, just to explain that. So yes, it is a competitive market, but it's important to keep in mind that ZT was a Tier 1 provider in that space competing with the time we use ODMs. So their manufacturing capabilities are second to none, right? And if you think about the facilities, the people and so forth. So we're very excited about that. Now certainly, there was the transition period that we had to work through, but we've had a plan for that and we've executed well to that plan all the way to back to what we said a year ago. Things have been happened exactly the way that we said even better than that. So we need to continue to execute on that because the growth profile of that end market in particular is massive. And so I think that's missing in our story today is the potential of that business, both accelerated compute and then the other 2 lines of business if we execute well. And I think that we've shown over the last year that we can execute well. But ZT had those capabilities, right? And so to your point, around the crowded space. So very focused on that. But more broadly, we've learned lessons over time. Sanmina has, certainly Juri has. It's good to be diversified. And there's a lot of opportunity in the other end markets that we play in. So communication networks, our legacy cloud infrastructure business, again, that's been growing 20-plus percent, and we don't see that slowing down anytime soon. Energy we're investing in. We mentioned a couple of quarters back about expanding into medium voltage transformers. That's certainly benefiting from the AI ecosystem. So pretty much across all of our end markets, aerospace and defense, we spoke about, medical, too. We're going to continue to invest in those. And we do have the balance sheet to do that, and we've shown that we can execute across that profile. So a lot of opportunity there. We're certainly up to the challenge, but we're very excited about the future. And we think the potential to both grow the business and expand margins is there, and we've been executing on that ever since I've been here, certainly, too, shown quarter after quarter that we can continue to grow and expand while still maintaining a healthy balance sheet and cash flow.

Got it. So we've covered a lot of different topics. So thanks so much for coming today and giving us all these details.

Yes. Thank you for having me. All right. Pleasure.

Thank you.