May 23, 2012
Singapore based Flextronics (NASDAQ:FLEX) is best known as an ODM for the likes of Hewlett-Packard (NYSE:HPQ) and Research in Motion. That business with its very miniscule margins and low return on investment has worn thin in the eyes of management. In 2010-11 with the collapse of the Blackberry and upheavals at H-P management began a process of re-balancing the company to be more flexible across all four of its verticals.
That process is still not complete but it is also looking quite prescient given that we are moving into a different world of computing in the next five years that may stun a number of analysts and long-time market commentators.
Flextronics saw a near collapse of its High Velocity Systems (HVS) business in fiscal year 2011 over 2010, dropping 38% to $1.96 billion. HVS sales are consumer products like ODM PCs and mobile phones. So, overall revenue for the year was down 6% but earnings, operating margins and free cash flow were all up. This is not an H-P path to earnings, like under CEO Mark Hurd, by cutting the janitorial staff and the R&D department to beat the street by a penny and keep the stock’s momentum up.
This represents a complete changeover of Flextronics business model, spreading itself across multiple industries to insulate itself from market specific declines. Offsetting the lost revenue in HVS, the other verticals all saw substantial gains, with the biggest coming from medical and automotive production, the High Reliability Solutions (HRS) vertical. HRS now accounts for 10% of total revenue with the company’s highest net margins after seeing 27% year over year growth to $638 million in revenue in the most recent quarter. Automotive growth was stunning with 32% year over year growth and sales nearing the $1 billion mark. Their latest win is a partnership with Sevcon (NASDAQ:SEV) to build drive trains for hybrid and electric vehicles for a number of European manufacturers.
The company is serious about these plans, targeting a 25% return on invested capital versus a weighted cost of capital of 8.5%, which will be achieved at a net margin of 3.5% and a further reduction of High Velocity revenue down to 30% of total revenue. The numbers for the fourth quarter 2011, ending on March 31st were 3% and 39% respectively.
The Post-PC Asia
Flextronics is well positioned in Southeast Asia with 17 facilities in China and others all around ASEAN, including Singapore, Malaysia and Vietnam. They have made the decision to break from FOXCONN’s (OTC: FXCNY) model and carve a different niche for themselves.
That niche comes in the form of employee retention. After the Lunar New Year the attrition rate in some places reaches as high as 60%. FOXCONN is only now bowing to pressure after a number of employee suicides. Flextronics HR solutions and focus on building employee facilities to minimize that turnover. As well, they have weighed China versus Malaysia for new sites, often choosing Malaysia due to the costs of intellectual property protection and lower value-added taxes offsetting higher labor costs.
Management looks at the changes that are happening in the consumer electronics space as worth pursuing as a value add over what is becoming their chief source of income: the higher margin, stickier repeat business of automotive and medical devices. The regulatory hurdles associated with becoming Tier 1 and Tier 2 suppliers to those markets make OEM’s less likely to ditch their supplier at a moment’s notice. Add in the fact that product cycles are longer and this is a recipe for long-term free cash generation that FOXCONN can only match with much higher volume.
The revenue generated on the low margin, short product cycle products become simply the froth on their earnings as opposed to the espresso itself. While the meat of their revenue will be generated by their Integrated Network Solutions Vertical, making servers and routers for Cisco (NASDAQ:CSCO). As more computing moves to the cloud the stand-alone PC will continue to be under attack as a useful tool. AMD (NYSE:AMD) is closing 3 of its data centers and consolidating them in order to maintain 100% utilization while controlling costs and minimizing taxes. Growth in the computing market will be seen in the server space, not at the desktop. Flextronics knows this, it is a waste of their expertise in rapid uptime design to stay on the mobile phone and video card treadmill.
So do industry leaders like H-P. This is what was behind the erstwhile plan to sell the PC division. H-P will be streamlining its consumer product lines, lowering the number of SKU’s and lengthening product cycles, while they re-focus on providing superior integrated server side solutions. While Flextronics business will be less dependent on any one vendor, like H-P, they will be well insulated from any mistakes they make.
Trading at a current multiple of 8.8 and with cash and shareholder approval to do another 5% share buyback Flextronics is a good value play for a forward thinking lean manufacturer. Watch their margins closely each quarter. If they hit their targeted 3.5% then the potential for this to become a dividend play comes into focus as well.