Flex Ltd.
Q2 2019 Earnings Call Transcript

Published: 26 Oct 2018

[Operator:]

Good afternoon and welcome to the Flex Second Quarter Fiscal 2019 Earnings Conference Call. Today's call is being recorded and all lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. At this time, for opening remarks and introductions, I'd now like to turn the call over to Mr. Kevin Kessel, Flex's Vice President of Investor Relations and Corporate Communications. Sir, you may begin.

[Kevin Kessel:]

Thank you, and thank you for joining us for Flex's second quarter fiscal 2019 conference call. We have published slides for today's discussion that can be found on the Investor Relations section of our website at flex.com. Joining me on today's call is our CEO, Mike McNamara; our Chairman, Michael Capellas; and our CFO, Chris Collier. Following their remarks, we will open up the call to questions with Chris, as well as our two business presidents, Paul Humphries and Doug Britt. Before we begin, let me remind everyone that today's call is being webcast and recorded and contains forward-looking statements which are based on current expectations and assumptions that are subject to risks and uncertainties and actual results could materially differ. Such information is subject to change and we undertake no obligation to update these forward-looking statements. For a discussion of the risks and uncertainties, see our most recent filing with the SEC, including our current, annual and quarterly reports. If this call references non-GAAP financial measures for the current period, they can be found in our appendix slides. Otherwise, they are located on the Investor Relations section of our website, along with the required reconciliations. Now, I'd like to turn the call over to our Chief Executive Officer, Mike McNamara. Mike?

[Michael M. McNamara:]

Thank you, Kevin. Before we begin our call, I want to take a moment to reflect on my announcement today, that I informed the board of my intention to retire at the end of this calendar year. After 24 years at Flex and having had the privilege to serve as 12 years as a CEO, I believe now is the time for me to step back and allow new leadership to continue improving on what we have built. It has been an amazing journey, and as we have built Flex into an incredibly powerful company that I'm extremely proud of, I want to thank our employees and customers for their support throughout our journey. Let me now turn it over to Michael Capellas, the Chairman of Flex Board, who would like to say a few words.

[Michael D. Capellas:]

Thank you, Mike. On behalf of the entire board, the leadership team and our 200,000 employees around the world, I would like to thank Mike for his dedication and leadership over the past 24 years. Since becoming CEO in 2006, he has built Flex into a global leader with $25 billion in revenues today. We will miss Mike's incredible passion for the business and we wish him the very best in his retirement. Mike will remain CEO of Flex through the end of the calendar year. The board, with the assistance of Heidrick & Struggles, has already launched a formal CEO search and we will consider external as well as internal candidates. Now, I'll turn it over to Chris.

[Christopher E. Collier:]

Thank you, Michael. As you have noticed, we delivered a solid quarter with results largely in line with our guidance. I'll begin with a summary of our most recent operating results. It will be important to share our focus on how we plan to respond to the current CTG challenges which are causing the majority of the reduction to our previous fiscal 2019 guidance. Outside of CTG, the remainder of Flex is very healthy and performing well, which we will also cover. Now, please turn to slide 2 for our Q2 income statement summary. Our second quarter sales were approximately $6.7 billion, up 7% versus a year ago and within the guidance range we've provided. Our Q2 adjusted operating income was $224 million, above the midpoint of our guidance range and grew 19% year-over-year. Our adjusted net income was $153 million, resulting in an adjusted earnings per diluted share of $0.29, which was also above the midpoint of our guidance range of $0.26 to $0.30. Second quarter GAAP net income of $87 million was lower than our adjusted net income due to several adjustments totaling $0.13, which resulted in a second quarter GAAP EPS of $0.16. Now, please turn to slide 3 for our quarterly financial highlights. While our gross profit grew 4% year-over-year to $433 million, we saw our gross margin decline 20 basis points to 6.5%. The gross margin pressure reflects unfavorable mix shifts, most notably, inside our CTG business. Our second quarter adjusted SG&A expense totaled $210 million, down 8% year-over-year. We remain confident in our ability to maintain cost discipline to drive productivity gains that will provide operating leverage as the business grows. Our quarterly adjusted operating income came in at $224 million, up 19% from the prior year, reflecting margin expansion of 30 basis points, for an adjusted operating margin of 3.3%. Several elements contributed to the improved results, notably, increased operating leverage in our CEC and IEI businesses, coupled with increased SG&A efficiency. Please turn to slide 4 to review revenue by business group. The evolution of our portfolio is a cornerstone of our strategy. All four business groups achieved year-over-year growth and we ended Q2 with a well-balanced distribution across both industries and customers we serve, with our top 10 customers totaling 43% of our sales and we have no customers above 10% of sales. While achieving year-over-year growth, our CTG business underperformed, as its revenues grew only 2% year-over-year to $1.8 billion, well below our expectation for 10% to 15% growth. Clearly, CTG performance has materially impacted the company's results and we will be focused on rebalancing the mix by addressing three major components of the business

[Kevin Kessel:]

Thank you, Chris. Operator, we're ready to poll for questions. As a reminder, in addition to Chris, we also have our business group presidents here to answer questions, Doug Britt, as well as Paul Humphries.

[Operator:]

The first question comes from Amit Daryanani of RBC Capital Markets. Please go ahead. Your line is open.

[Amit Daryanani:]

Thanks a lot. Good afternoon, guys. I have two questions. And first off, best of luck, Mike, in the future. Yeah, maybe the first one, I just want to understand what do you guys think went wrong with the NIKE relationship for you, because there was a ton of confidence from both you and NIKE up until a few months ago. So, what do you think went wrong and what are maybe a couple of things Flex has learned from this thing that – from the NIKE dynamic that helps us prevent something like this happening again in the future?

[Christopher E. Collier:]

Okay, I would say that we are disappointed where we sit right now. We're limited in what we can say as we're in the midst of negotiating the terms of disengaging with NIKE. What I can say is we actively build out our operation into a productive system that we are proud of. Part of fixing it was developing the commercial agreement where Flex shareholders would have a sustainable return, and we were unable to come to that agreement with our partner, thus, this decision. I think as we step back, NIKE was extremely unique and differentiating, and I think that it was an important feature that we went after and we are just being very thoughtful at this stage in terms of where we sit. And since we can't get to a commercial agreement where our shareholders – where this is (28

[Amit Daryanani:]

All right. I guess, broadly, when I think of the Flex portfolio today, right, I mean, you guys are doing – you mentioned CEC is doing better than you expected. HRS, IEI doing really well, could you just talk about why do you even want to keep investing in the CTG business as you go forward? Because if I think about all the challenges you've had in last seven, eight years, they tend to originate from this segment, right, be the BlackBerry or PCs or now NIKE. So, why even bother to keep investing in this versus maybe just run this as cash cow and invest in the other three businesses which, I understand, have lower growth potentially, but seem to be a lot more sustainable with less headache?

[Christopher E. Collier:]

Yeah. Certainly, we've seen a lot of volatility with that business. There are benefits that we see with operating that within our portfolio. However, that needs to be at a very metered level. We get benefits in terms of technology adoption. We scale across our – and leverage our overheads as well as supply chain. So, we're going to be hyper-focused with regards to the contribution level in our portfolio that it plays and we're going to be very selective as we move forward with who we partner in that space. We are focused on margin and not revenue inside of this business. But as we were highlighting, we've been making significant investments across the rest of the business that's performing very, very well. We've amplified the level of investment we put to HRS and IEI and that remains a focal point. So, I think that – well noted the volatility in CTG, and I think what you're going to see is a much more metered approach, very selective, very disciplined in terms of operating that within our portfolio, with a focus on our business driving greater margins, driving better earnings leverage and having real strong, sustainable underlying product lifecycles.

[Kevin Kessel:]

Next question, please.

[Amit Daryanani:]

Perfect. Thank you.

[Operator:]

Your next question comes from the line of Mark Delaney of Goldman Sachs. Please go ahead. Your line is open.

[Mark Delaney:]

Yes, good afternoon. Thanks for taking the questions. First question, I was hoping, with the updated guidance, you can help us understand the full-year losses that NIKE is contributing to this year's numbers. And I understand that the goal is to end that relationship by the end of this fiscal year. Do you anticipate having stranded costs that can maybe last beyond the end of this, I'll say, the calendar year? Do you anticipate losses or stranded costs continue after the end of the year?

[Christopher E. Collier:]

Certainly, Mark. As we highlighted, we will be winding down that operation by the end of December. That will cease – we had guided the Q3 to include losses for NIKE in the same range, stable with what we just absorbed in Q2, and there will be no losses as we move forward. We will cease that business. So, that's been contemplated in how we structured and guided our Q3. And as we talked about earlier in the year, those losses had been abating as we move through this cycle.

[Mark Delaney:]

Okay. And then, for a follow-up question on CTG, more broadly, maybe you can just give us a better sense of the scope of the magnitude that you're considering within your CTG portfolio. It seems like there's maybe business that Flex will be disengaging in and trying to get a sense for how much revenue that potentially encompass. Thank you.

[Christopher E. Collier:]

Certainly. I'll let Doug weigh in here on CTG.

[Douglas Britt:]

Hi, Mark. How are you doing? So the overall CTG business, what we're looking at is we've been actively pruning the engagements with loss-making accounts over the last six months. We are revamping our go-to-market. We concentrate on the larger customers that have a broad portfolio of products and we're very disciplined on our commercial management to ensure that the business we bring is achieving the profitability levels within our guided range. So, we've been doing a lot of pruning in the business. It's taking some time. It's taking some effort. We're confident that we'll reposition the portfolio and we'll get this business back on track.

[Mark Delaney:]

Okay. Maybe just to ask it a bit more simply, I mean, there's a number of issues going on in CTG and it seems like some of these issues could take quarters to – or several quarters to resolve. So, is there a timing we can have in mind to when CTG is back within the target margin range?

[Christopher E. Collier:]

Yeah. Clearly, one of the things we identified here is that it'll take over the remaining part of this year. We'll be underperforming. And that is really not going to happen in fiscal 2019. We do take time and does the same. We're very active right now in going through the portfolio and eliminating those customers that are not viable long term, not strategic and do not provide a returning cash flow sufficient for the company. We would expect significant improvement as we move forward into 2020. We're just reassessing, as Doug highlighted. We're assessing multiple product categories, eliminating some of the businesses that we've been entering into, and just really honing in and refining and streamlining our engagement around CTG.

[Mark Delaney:]

Understood. Thanks very much.

[Operator:]

Your next question comes from the line of Adam Tindle of Raymond James. Please go ahead. Your line is open.

[Adam Tindle:]

Okay. Thanks and good evening. So I just wanted to start, fiscal 2019 EPS was taken down by $0.15 for remaining two quarters. Can you maybe just help us think about fiscal 2020 EPS in light of this? Would it be fair to annualize the reduction today and think about a $0.30 hit to the $1.55 you talked about at the Analyst Day or does the lack of NIKE losses provide some offset? Just any help with the buckets would be helpful.

[Christopher E. Collier:]

Yeah, certainly. Where we sit today, we just don't think it's appropriate to endorse getting back out really into 2020 with a lot of uncertainty in terms of the tariff environment. But what I can tell you is when you think about how we were moving the portfolio to achieve at 2020, there's a large part of our business that is intact. If you think about the IEI business and where it's growing and the record bookings it's coming off of back inside the target margin range, its contribution will be healthy for next year. HRS, likewise, it's coming off of record bookings right now. It will healthily stay within that margin range and we see its contributions nicely into next year. Jump into CEC, we're really pleased with where it has returned to growth and it's centered itself well within its margin range. And again, we've been positioning ourselves with some nice underpinning customers and programs that give us a degree of confidence as we move into next year. It just rather points back into CTG. And so, a lot of volatility there, a lot of uncertainty, as we have bridged out that view last time, we had thought of that, it was contributing pretty meaningfully to our growth. And obviously, the NIKE will be eliminating that loss that we carried this year. So, that's a plus in terms of year-over-year. So, CTG is just going get healthier as we move forward. It's going be a lot smaller than anticipated. And I would say on balance, the rest of the moving parts that we had identified are largely intact. So I think just step back and if you think about it, it's the CTG area that we're focused on. It's going to take a little time. It's going to be depressed from the levels we had anticipated but the rest of that business is growing and positioning itself as intended.

[Adam Tindle:]

Okay. And maybe just as a follow-up, if Mike could comment – and best of luck in future endeavors – but I'd imagine one of the questions that might come up tomorrow for us is NIKE was supposed to embody the move of non-traditional customers, the EMS and moving more towards strategic relationships with customers. Can you just maybe reflect from an industry level perspective how we can think about whether or not the thesis is still intact and why this development today is more of a one-off than a case study? Thanks.

[Christopher E. Collier:]

Yeah, certainly. I'll answer for Mike.

[Michael M. McNamara:]

Yeah. Go ahead, Chris. Thanks.

[Christopher E. Collier:]

NIKE was something that was unique and it was positioned in a completely new industry that we're trying to revolutionize. We are entering into many different arrangements with many different customers on finding new ways to engage our platform and not to stray far from our platform, our capabilities and competencies and engage in meaningful ways to grow the business. I would think that we'd shown some examples of those at our Investor Day, where we've done so. And I would just probably turn this over to both Doug and Paul to maybe elaborate how we're playing differently within their spaces.

[Douglas Britt:]

Yeah, we've articulated it in our Investor Day, but the platform that we have, the overall global regionalization and digitization that's happening across industrial is accelerating. We've got a solid pipeline. And what's happening as this digitalization is moving forward, these customers are looking at how they modernize their supply chains and bring new supply chains in new markets with new technology. That's why you see really the strength of our bookings and revenue and margin expansion over the last five years in the industrial business. If you look at what's happening in the CEC business, there are some structural shifts that are occurring in CEC. We have the beginning of the build-out of the 5G network and network connectivity infrastructure is being built out now. We're benefiting from the bookings that we recorded back in Q4 that I articulated at our Investor Day. We're also seeing the acceleration of cloud opportunities across a bunch of new customers that we've revamped our approach with. That market is changing also the way that they're looking at sourcing decisions. They're look at more regional plays. They're looking at partners that can protect IP. Data security is important. And it puts us in a very strong position because we're very strong globally and we're very strong regionally and it provides an opportunity for us to bring a unique business.

[Christopher E. Collier:]

Maybe Paul can add to that.

[Paul J. Humphries:]

Yeah. From an HRS perspective, you've heard me talk in the past about the value of leveraging the competencies that exist across for that – to Flex to be able to target new markets in automotive. We see that key area focus for us going forward is autonomous, where we've been able to leverage the expertise we have in our service delivery group to develop new solutions for some of the key OEMs in the autonomous space. That complete (40

[Christopher E. Collier:]

Just to recap, I think we are just going to continue to move into some of these non-traditional markets, such as industrial, such as automotive and medical, where we can benefit from the greater margins, the underlying product lifecycles, and we just are not going to stray too far from our core.

[Kevin Kessel:]

Next question, please.

[Operator:]

Your next question comes from the line of Steven Fox of Cross Research. Please go ahead. Your line is open.

[Steven Fox:]

Thanks. First off, I was wondering if you could maybe elaborate on some of the constraints you're having in India. Is it – relative to 90 days ago, was it an execution issue on bringing up planned capacity or is this unplanned demand that you're having trouble meeting? And then, I had a follow-up.

[Christopher E. Collier:]

Yeah, certainly, Steven. What we have is we've had significant amount of demand that we're undertaking. And we've been having some challenges bringing up capacity, capacity being in terms of the facility necessary as well as other line capacity, given some challenges just in the infrastructure that exists over in India. In particular, we had a facility that just taking longer to come online than anticipated and that's going to take us a bit of time into the back end to this year to bring on that capacity to then be in line with the demand that exists today. But we're being very thoughtful in terms of the levels of investment that are going to go into that and how to support that capacity need, and be very measured.

[Steven Fox:]

Understood. And then, just in terms of the IP that was developed around the NIKE relationship, can you talk about whether you keep ownership of any of it or does that all go to NIKE? What happens with some of those assets? Thanks.

[Christopher E. Collier:]

Yeah. Steve, we're just not going to be able to expand much on that. We're pretty limited right now as we're in the midst of negotiating in terms of the disengagement with our partner. So, we aren't going to address that.

[Steven Fox:]

That's fair enough, Chris. Maybe just put another way real quickly, how do you look at just sort of your broad base of technology skills? Is there things now that you have to tear down based on some of the experiments you've gone through in the last couple years or do you think that everything that you have is still applicable in one way or another? And that's all I had.

[Christopher E. Collier:]

Certainly, Steve. So, I mean, there's a fair amount of good learning and benefits that we've captured in terms of automation and other activities in terms of manufacturing that are transferable into other areas of our business. I think if you look across broadly the portfolio, there's really no other area that we're stretching beyond our core or beyond our capability. So, I think that we are – what you're hearing from us is a real measured approach and a refinement in terms of how we really think about one area being CTG. But more broadly, I think we have a good, deep set of expertise and skill set that's building, that's enabling us to win significant new parts of business. So, that's where our focus is going to be.

[Steven Fox:]

Thank you very much.

[Christopher E. Collier:]

Thanks.

[Operator:]

Next question comes from the line of Paul Coster of JPMorgan. Please go ahead. Your line is open.

[Paul J. Chung:]

Hi. This is Paul Chung on for Coster. Thanks for taking my question. So given the NIKE lessons learned, how much tradeoff on kind of revenue growth should we expect as you look for more margin-accretive deals?

[Christopher E. Collier:]

So, I'd like to just start by highlighting, if you think of the portfolio evolution that we've been under and even in terms of just this past quarter, the level of revenue expansion that we've seen in our non-traditional areas such as IEI and HRS, and the capture rate that we have of over 60% of profits there, both of those being inside of target margin ranges, both with record level revenue, both with record level bookings. I think that you're seeing us building a very strong book of business and ability to compete and win significant business as we move forward, and that's exactly where our focus is going to be.

[Paul J. Chung:]

Okay. And then, just on the CEC segment, you had a nice spike there. So with scale, do you expect kind of operating margins to trend the higher end of the CEC range maybe in fiscal year 2020? Thank you.

[Christopher E. Collier:]

I'll just give my view here and I'll let Doug expand. But we're very pleased with the trajectory that CEC is on right now. It's returning to growth. It's now moved its way back into its margin profile. It's benefiting from a good mix of business as we've shifted to greater percentage inside of the cloud data center as well as 5G developments. And we're benefiting greatly from capacity utilization, given the greater volumes we're running through that business. So, we have our stated range for a purpose. I think we're pleased with entering into that range and we would anticipate staying well within that range as we move forward. Do you want to expand?

[Douglas Britt:]

Yeah. This is Dough. Our investments in design and engineering have been yielding. We've been developing deeper relationships with our customers by adding more value. And there's such a disruption occurring in this market and we're in a very good position to benefit from this disruption based on all the different locations we operate and the supply chain we drive globally. So, it's great to see the team work so hard to get this business growing again. So, I'd like to congratulate the team for a great quarter.

[Paul J. Chung:]

Thank you.

[Operator:]

We have time for one more question, and that is from Matt Sheerin of Stifel. Please go ahead. Your line is open.

[Matthew John Sheerin:]

Yes, thank you for fitting me in. Just another question regarding the CTG revenue shortfall, at midpoint, you're looking at down 15% year-over-year. So, that's roughly $350 million or so. What percentage of that is due to the issues in India and unable to ramp into your previously – projections versus deselecting revenue versus expectations that you had for NIKE revenue in the quarter?

[Christopher E. Collier:]

Yeah. Hey, Matt, this is Chris. There's no impact in terms of that from NIKE – no meaningful impact from NIKE. As we were highlighting, the majority is from delayed ramp inside of the India, but as well significant repurposing, revisitation and refinement inside of the core CTG, as Doug alluded to, as we're thinking through that business and how we refocus efforts. That core has actually had more of an erosion on a year-over-year basis that's implicating that type of a guide.

[Matthew John Sheerin:]

And looking to – I know you don't have a ton of visibility into your March quarter, but should we assume that it's going to be down year-over-year in a similar rate if you kind of flow through the seasonality in that business?

[Christopher E. Collier:]

Yeah, I would say that we anticipate having several of these sustained aspects continue. Our fiscal 2019 guide already reflects CTG continuing to have pressure. I would say that we will be rebalancing that portfolio, and as I also highlighted, we will be under pressure in terms of the margin as we go through that transformation.

[Matthew John Sheerin:]

Okay. And then, relative to the capacity that you have now in Guadalajara due to NIKE, I believe that was like 1 million square foot facility. So if you think about it in terms of deploying your traditional printed circuit board assembly equipment, et cetera, what kind of revenue capacity will we be looking at, because that would be an opportunity, as you said, your customers shifting out of China to places like Mexico. So, what should we think about the opportunity to fill that capacity?

[Christopher E. Collier:]

Yeah, certainly. As we highlighted in the prepared remarks, we're working hard and striving to retain most of the affected employees, as well as to repurpose the factory capacity in Mexico. We're active in negotiations with NIKE. I think the other point to notice is that we highlighted the tariff environment is providing a lot of discussion with current and prospective customers around relocating business away from China into other regions. That regional distribution is going to be heavily seen inside of Mexico. We have the largest footprint and capability set to offer customers inside of Mexico and I would anticipate our ability to partner in an effective way, we'll be seeing.

[Matthew John Sheerin:]

Okay. And just a quick follow-up, you just mentioned that you used the term negotiate with NIKE. Does that mean there could be some settlement in terms of some of the costs that you've incurred or they'll share some of those costs?

[Christopher E. Collier:]

Yeah, Matt, clearly, we're going to be limited in what we can say with regards to that. We're really in the midst of negotiating terms of the disengagement with them, and we'll leave it at that.

[Operator:]

I would now like to turn the call back over to Mr. Kessel for closing remarks.

[Kevin Kessel:]

Thank you, and thank you for dialing in. We will see many of you at upcoming conferences, RBC and Raymond James. This concludes our call.

[Operator:]

This concludes today's conference call. You may now disconnect.