Notes from the Annual Meeting.
I attended the Annual shareholders meeting on Friday. Attendance was quite light, and so I got a chance to talk to Micheal Marks quite a bit. Before I get started, I will recite my normal disclaimer:
These are my interpretations of comments made at the meeting, and may not accurately reflect the statements made by management in all particulars.
Marks went through a presentation that he had given to analysts at several tech conferences this month. Basically the presentation was a discussion of potential reasons (rumors) why the stock might be down, and rebutted each reason. The main points:
1. Customers warn- and investors hit Flextronics irregardless of what biz they actually do for the customer. Case in point: Ericsson earning warning several weeks ago. Ericsson's cellphone and switch businesses are poor, but Flextronics makes PBX, radio units, and European cordless telephones for Ericsson ( Marks said they would love to make cellphones or switches though). The news simply didn't have any impact on Flextronics. Bad news at AFCI and Alcatel also seemed to cause investor concerns, but these customers are each less than 10% of sales. Flextronics still seems to see growing business from them.
Marks emphasized the portfolio of customers that they had, even showing a pie chart showing the relative size of business from each customer product line/ division (no hard numbers). This was an impressive chart. Only one Ericsson division had a really big piece. (more about the Ericsson business later)
2. Margins are dropping. It is true that margins in the sector are dropping somewhat. Marks even referenced the drop in margins in Solectron's latest report. Marks says that gross margins are dropping due to several factors:
- Due to more big contracts (sector trend). There simply is a smaller margin on a $100M+ contract than on smaller contracts. They cost less on a percentage basis to set up and administrate.
- The company (and sector) is "growing like mad" and this puts a strain on margins.
3. News of Layoffs in SJ. Marks indicated they laid off some people in San Jose recently when they moved some Cisco and WebTV work to Mexico, and AFCI work to China. Even after the layoffs, they still have almost double the plant workforce in San Jose from the beginning of the year.
4. Some investors have concerns about the "F" in the trading symbol, connotating a foreign company, and hence having foreign exposure. They really have a well diversified global company.
5. Malaysian currency controls. Flextronics has a relatively small facility in Malaysia (only Scotland is smaller). But they don't do business in ringgits there, but rather in USDs.
6. Eastern European business potentially impacted by problems in Russia etc. Right now all of Hungary's production is exported out of Eastern Europe. In the future, they will be sending some product into Eastern Europe from Hungary. (Incidentally, the Hungarian plant sits on 'foreign' land technically part of Western Europe and has their own custom house, similar to a foreign embassy.)
The same thing is true of their Latin American operations; they currently export most of their production, but will be selling into Latin American markets in the future.
7. There is news that HP is really hitting their vendors to tighten margins (particularly SCI Systems). This seems to be carrying over to the sector. Flextronics didn't have a lot of work from HP until recently. The margins on the PC and peripherals products is tight, but doesn't hit Flextronics particularly hard, since they don't do much in the PC sector yet. But they will be getting a lot more PC sector work over the next several quarters.
Marks says that people who focus on margins alone, misunderstand how the sector really works. Returns on capital and other metrics are much more important. In fact, he predicts the largest five players (SCI,SLR,CLS,JBL,FLEXF) will see the differences between their historical margins shrink a bit as they all seem to be picking up similiar new business.
8. PCB business is weak - Margins in the board manufacturing business are under pressure. This business has been in a world-wide slowdown and major players have had significant revenue declines and pricing weakness. Flextronics has their Astron subsidiary, and at the current time pricing in this business has weakened to the point that this subsidiary is losing money for the first time. Fextronics still likes this business long term. Marks says that it is a capex intensive business, and they are seeing capacity being retired instead of spending the capital to upgrade, particularly in Asia (!!??).
9. Concerns over 'In-sourcing' by customers. Jabil announced the in-sourcing move by 3Com for some business in one of their conference calls. This seemed to set off some concerns that other customers may be moving in this direction. Marks says 3Com's move was the "exception" and that overwhelmingly the move to 'Out-source' has accelerated. Out-sourcing is the industry trend.
Marks went on with a lot of other info about Flextronics, but most readers of this board know most of it, or can get the same info by reading the Chairman's letters and viewing the Earnings presentation slides on Flextronic's home page.
I had the opportunity to ask a bunch of questions at the close of the meeting and Marks talked to me one-on-one for awhile. Here's some of the things we talked about.
I pointed out the pattern of the big 100,000 share blocks seemingly sold every 4-5 hours in only 10 minutes or so. I indicated that it seems that over 1 million shares had been sold in this way. He doubted it was a single seller, since we didn't have a single shareholder that large, except some long term holders that intended to hold for a long time (Sequoia and Baron). I noted the SEC filings where insiders who had sold their companies to Flextronics for stock, could sell somewhere in the neighborhood of 3-4 million shares anytime. He seemed puzzled, and kept a perfectly straight face; I got the impression that insiders have not been selling anything significant. He doesn't seem to know of a large seller, although perhaps Putnam had a large position. (Note: If a large holder didn't sell, then the possibility exists the selling was done by a short seller - this poses some interesting possibilities. We should keep an eye out for the next short interest report.)
I asked some questions about the Qualcomm deal. He said the deal wouldn't involve as much capital investment as I quoted from one of the news reports; the capex from Flextronics would be less than $10M. Flextronics will be manufacturing the cellphones for the joint venture. When I asked about the CapEx for this year, they had previously mentioned Capex in the $90-100M range, but would like to spend more than this if "good opportunities came along". (Note: I got the impression from Mark's big smile, that good opportunities are coming along.) The original estimated Capex would support growth in the range of analyst estimates, but they hope to grow faster. Marks mentioned that they still have a $100M credit line.
The Qualcomm deal will mean in the order of $100M in new business for Conexao. I asked Marks if they knew about Qualcomm's business when they bought Conexao... the answer was No! It's a good deal for Conexao, but wasn't in the original purchase plans! In addition, Conexao has gotten another large customer contract. (Brazil is looking good, guys.)
I asked about Ericsson's Karlskrona, Sweden plant, and what would happen when the three year contract they received when they purchased the plant runs out. Marks said that they should just keep on running. The PBX business isn't growing, but has a 'long tail' and this business should keep on going for maybe another 10 years. They have gotten two new customers into the plant; a Norwegian company's power supply biz and an English company's RF product biz. Marks said that business relations with Ericsson have been pretty smooth, since they hired their management staff from Ericsson and there were few transition problems. (Other ECM companies working with Ericsson had more transition problems, since they were moving business to their plants etc.) The Ericsson deal has worked out really well, and opened a lot of doors.
Marks also felt the Neutronics deal was a good deal for Flextronics. He said there are no other comparable businesses available for other companies that want to set up in Central and Eastern Europe. I asked how he got that deal, and he said the race often doesn't go to the biggest, but to the fastest.
Overall, Marks seemed very pleased with the direction of the company and new business opportunities. I mentioned the fact that had been quite a number of $100M+ deals outsourced by major OEMs recently, and asked him about whether Flextronics was getting their share of the new business. He answered with a strong affirmative.
Marks thinks that the major assemblers will do very well over the next 5-10 years. He believes that the outsourcing wave will take ten years to play out. He took issue with my estimate of five years. He even said anyone who bought a basket of the five largest ECM stocks, and held for five years, should be very pleased. He expects Flextronics to be doing $10B annually within five years.
I came away with good feelings. He can't understand the drop in Flextronic's stock price either.
Paul
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