Acquisition gives Flextronics expanded global footing and capabilities

Flextronics company profile

Flextronics is the second largest electronics manufacturing services (EMS) provider in the world, with its second place position secured in October 2007 through the purchase of EMS industry competitor Solectron. Flextronics’ major markets include computer, mobile phones, consumer electronics, industrial electronics, automotive electronics, aerospace electronics, marine, telecommunications and medical electronics and devices.

In FY07, Flextronics’ largest segment was mobile phones, which accounted for over 30% of revenue. With the acquisition of Solectron, Flextronics’ largest segment will be infrastructure, with roughly 30% of revenue generated in this segment. Flextronics’ major customers include Casio, Cisco, Dell, Kodak, Sony-Ericsson, Hewlett-Packard, Kyocera, Microsoft, Motorola, Nortel, and Xerox.

The Solectron acquisition adds IBM, Lucent, NEC, Thomson, and Teradyne. The combined company will operate roughly 24.2M square feet of manufacturing facilities located worldwide with more than 192,500 employees. Flextronics is incorporated in Singapore and has its U.S. headquarters in San Jose, California.

Recent analysis from Deutsche Bank Equity Research evaluates the ‘new’ Flextronics as the company integrates Solectron into Flextronics’ growing global footprint. According to Deutsche Bank Equity Research, with some interpretation from VentureOutsource.com, Flextronics has been a consistent executor, with above-average margins and the best balance sheet management in the EMS industry.

Flextronics is seeing rapid growth in new markets such as mobile phones and emerging segments, and is now targeting notebooks as a growth opportunity. Deutsche Bank favors Flextronics’ recent Solectron acquisition as it adds diversity to Flextronics’ revenue base and the firm believes Flextronics will be successful in applying its low-cost model to Solectron’s business.

Flextronics already has a solid presence in the mobile phone market, and has now announced plans to target the notebook segment with its acquisition of Arima’s notebook PC and server assets. The notebook market has seen strong growth in recent years, up 21% in 2005, 17% in 2006, and forecasted to be up 21% in 2007. Deutsche Bank believes Flextronics’ success in the mobile phone segment, and the acquisition of Arima, position the company well to compete in the notebook market.

Deutsche Bank believes Flextronics had two objectives for purchasing Solectron:

1. taking capacity out of the industry, and
2. amassing Flextronics’ scale to match Hon Hai, the current market share leader in the EMS space.

Hon Hai also has 20% share in the computing segment where Flextronics is targeting growth in notebooks.

Flextronics, EMS industry risks

EMS stocks have historically been volatile due to the high fixed cost nature of the business which leads to significant swings in profitability. In addition, the industry is also dependent on OEM sales, which is driven by the health of the overall macroeconomic environment.

In Flextronics’ case, company-specific risks include difficulty in integrating the Solectron acquisition, an inability to return to previous operating margins due to the Solectron acquisition, the loss of a significant customer such as Sony-Ericsson, and a faster-than expected decline in the global economy.

Flextronics acquiring scale to match Hon Hai

As mentioned above, Deutsche Bank believes Flextronics had two reasons for acquiring Solectron: (1) taking capacity out of the industry, and (2) amassing scale to match Hon Hai.

Hon Hai is currently the market leader in the EMS space with 25% market share in 2006 (Foxconn plus Foxconn International Holdings in Figure 1).

Hon Hai has grown revenue 45% in 2006 and is expected to grow roughly 30% annually over the next two years. A significant portion of this growth is due to Hon Hai’s strong position in the mobile phone and notebook markets. As seen in Figure 2, more than 90% of the company’s revenue comes from consumer devices (mobile phones and flat panel TVs), and computers. In addition, Hon Hai has benefited from OEM relationships with Apple and HP, both of which are gaining share in the PC market.

While Deutsche Bank believes Flextronics is not specifically targeting Hon Hai, Flextronics will begin to see Hon Hai as a competitor in more engagements as Flextronics moves into Hon Hai’s core computing and consumer device markets. Meanwhile, it could be reasonable to expect Flextronics to be more successful at taking share from smaller original design manufacturing (ODM) notebook providers as Flextronics ramps up its offerings.

Notebook opportunity

At its Analyst Day in November 2007, Flextronics outlined plans to go after the notebook market. The global notebook market segment is dominated by Asian ODMs which account for roughly 64% of the revenue. As seen in Figure 3, Hon Hai is the largest competitor in this segment, with 20% share, followed by a number of other ODM vendors.

EMS vendors such as Sanmina-SCI and Flextronics, only account for 4% and 2% of computer segment revenue, respectively. While computers were once an EMS stronghold, ODMs have taken over this segment with their focus on designing and then manufacturing products in high-volume.

In general, EMS vendors have shied away from an ODM model to focus instead on joint development for more high-end products. Flextronics has been the only EMS vendor to embrace an ODM model in some segments of its business, applying this model to its mobile phone business and now looking to exploit its ODM experience in the notebook market.

To further support this move into notebooks, on September 10, 2007, Flextronics signed a letter of intent with Arima Computer to purchase the company’s notebook PC and server operations for roughly $192M. Arima gives Flextronics the design and manufacturing capabilities that Flextronics needs to be vertically integrated in the notebook space, as well as access to Arima’s 600 design engineers. In addition, Flextronics will gain access to Arima’s largest customer, Gateway (now owned by Acer). The sale is expected to close in March 2008.

Over the past few years, ODM revenue growth has outpaced EMS revenue growth, with the ODM market growing 26% in 2005 and 23% in 2006, versus the EMS market at 16% and 21%, respectively.

Deutsche Bank believes this is, in part, is due to ODM’s product exposure to higher growth segments like notebooks and mobile phones. As seen in Figure 4, notebook revenue has seen strong growth since 2003, with growth rates of 21% in 2005, 17% in 2006, and expected to grow 21% again this year. This is in contrast to more traditional EMS sectors such as telecom, peripherals, and servers and storage, which grew EMS revenue at 8%, 7% and 17%, respectively in 2006.

Deutsche Bank believes Flextronics’ success in the mobile segment and the Arima acquisition position Flextronics well to compete in the notebook segment. In addition, the firm feels many OEMs are concerned with direct competition created by some of the ODMs as ODMs enter the branded market (i.e., ASUSTeK, BenQ). As a result, it is believed OEMs will be willing to look to Flextronics as a non-competitive supplier of notebook computers.

Solectron acquisition

Currently, Deutsche Bank believes the largest issue for Flextronics is integrating the Solectron acquisition. While Flextronics has outlined a confident plan for rationalizing the combined company, numerous issues could surface making these plans more difficult than expected.

In November last year, Flextronics indicated it believes the integration can be achieved in 6 months with after-tax synergies in excess of $200M. While the company expects that it will see some revenue leakage, it expects that this will be less than $1.5B. Flextronics also indicated it will sell or shutdown 19 of the combined company’s services and manufacturing facilities: 5 in Asia, 6 in the Americas, and 8 in Europe.

As seen in Figure 5, above, Flextronics expects to reduce roughly 4.1M square feet of manufacturing, bringing its total manufacturing capacity to 24.2M. In addition, as seen in Figure 6, below, the company will reduce its headcount by 12.5M, with a combined headcount of just over 192M when completed.

It is hard to assess how successful Flextronics’ plans will be, and Deutsche Bank believes Flextronics will have to deliver on these expectations for industry investors currently on the sidelines to buy into the story.

Yet, while Flextronics still needs to deliver on the Solectron acquisition, Deutsche Banks likes the acquisition because it gives Flextronics scope and scale to compete.

In addition, Solectron’s customer segments were more heavily weighted toward infrastructure and servers, while Flextronics has more exposure to the mobile and consumer digital segments.

As seen in the following Figures, Figures 7 displays Flextronics’ previous revenue base by market segment. Figure 8 displays Solectron’s revenue bases by market segment.

Whereas, Figure 9, below, displays the combined company’s revenue base by market segment which results in a more diversified revenue base. Deutsche Bank believes this could possibly help Flextronics with performance challenges from fluctuations in any one market segment.

In addition, the different product focuses of the companies lead to little overlap of the customer base, with the combined company having less than 60% of its revenue coming from its top 10 customers. This diversification could help Flextronics buffer downturns in any one market segment.

Management execution

Flextronics is one of the few EMS vendors to deliver relatively consistent operating margins and returns on invested capital (ROIC). Flextronics’ operating margins since 2001 have generally ranged between 2% and 4%, with an average of 2.9% during this period.

As seen in Figure 10, over the past three years, Flextronics’ margins have been consistently within 10 to 20 basis points of the industry’s average 3% margins.

On a ROIC basis, Flextronics has also delivered relatively consistent results, with an average ROIC of 7.3% (Figure 11).

In addition to delivering relatively consistent operating results, Flextronics has the lowest inventory days and the lowest cash conversion cycle (CCC) of the top four U.S. listed EMS vendors.

Flextronics’ average inventory days since C1Q01 are 40 days and its average CCC is 21 days, the lowest in the industry on both metrics. As seen in Figure 12 and Figure 13, Flextronics has consistently delivered lower CCC days than its competitors. To some extent, this balance sheet discipline relates to its product exposure.

However, considering that Flextronics is vertically integrated, which means components inventory will stay on Flextronics’ balance sheet for longer, Deutsche Bank believes these metrics can be considered impressive.

In addition, Deutsche Bank believes Flextronics will be able to apply its disciplined balance sheet approach to its acquisition of Solectron, which had inventory days of roughly 56 and a CCC of 41 days. Flextronics estimates that reducing these metrics will result in roughly a $475M cash savings.

Top EMS customers for Flextronics

All of Flextronics’ revenue comes from sales to OEM customers. Major customers for the company include Sony-Ericsson, Hewlett-Packard, and Nortel. In June 2004, Flextronics won a significant contract from Nortel, with this customer bringing in close to 10% of the company’s revenue. In addition, Flextronics has a strategic relationship with Motorola. (See Figure 14)

Other Flextronics customers include Casio, Cisco, Dell, Kodak, Kyocera, Microsoft, Sun, and Xerox. Solectron’s top customers in FY06 were Cisco, at roughly 20% of revenue, and Nortel. Other top Solectron customers include Alcatel-Lucent, IBM, Hewlett-Packard, NEC, and Teradyne.

While 64% of Flextronics’ revenue came from its top ten customers in FY07, the company estimates that combined with Solectron, less than 60% of its revenue will come from its top ten customers. Of these, the only customer accounting for greater than 10% of company revenue will be Sony-Ericsson.

Flextronics product segments

On a standalone basis, roughly 30% of Flextronics’ revenue came from the mobile segment, with the consumer digital and infrastructure segments representing 23% of revenue in FY07. Computing represented 10%, with industrial electronics; auto, medical and ‘other’ making up the remaining 10% of revenue in FY07.

Solectron’s standalone business was more heavily weighted toward the computing and infrastructure segments. (Infrastructure represented 40% to 45% of revenue due to Solectron’s strong relationship with Cisco) Computing represented roughly one-third of Solectron’s revenue, with consumer digital representing just 10% of Solectron’s revenue. Solectron had no exposure to the mobile segment. As seen in Figure 15, the combined company has a more diversified revenue base.

The largest segment will be infrastructure at roughly one-third of revenue, with the remaining 4 product segments representing between 10% to 20% of revenue.

Flextronics manufacturing and geographic detail

Flextronics’ standalone revenue mix was primarily weighted toward Asia, with 60% of revenue coming from this geography in FY07. Americas accounted for 25% with Europe at roughly 15%.

Solectron’s standalone revenue was more heavily weighted toward the Americas, with 46% of revenue coming from the Americas in its last quarter. As seen in Figure 16, above, the combined company will have just over 50% of revenue coming from Asia, with roughly one-third of revenue generated in the Americas. Europe will remain at roughly 15%.

As seen in Figure 17, below, Flextronics has roughly 17.6M square feet of manufacturing facilities and Solectron has 10.7M, with combined square footage of 28.3M. Flextronics’ rationalization plans call for 4.1M to be closed, netting out to 24.2M square feet of manufacturing facilities once Flextronics’ plans are complete.

Deutsche Bank’s analysis of Flextronics’ and Solectron’s manufacturing locations suggests Flextronics has a higher percentage of its manufacturing facilities in low-cost geographies, at roughly 75%.

Flextronics’ largest facilities are located in China, Malaysia, and Mexico. On the other hand, Solectron’s manufacturing capacity is more heavily weighted to high-cost geographies, with only 38% of its area located in low-cost countries. A significant portion of Solectron’s manufacturing capacity was located in the U.S., accounting for roughly 35% of its square footage.

As Figure 17 suggests, Flextronics will close a significant portion of its combined manufacturing square footage in the Americas and Europe which should help Flextronics retain its competitive manufacturing costs.

Where it all began…

Flextronics was founded in 1969 by Joe McKenzie and, at its inception, was engaged in the manufacturing of printed circuit boards (PCB) for technology companies. In 1980, the company was sold to Bob Todd, Joe Sullivan, and Jack Watts who expanded Flextronics’ operations as a contract manufacturing company.

In 1987, Flextronics went public under the ticker ‘FLEX’ on the NASDAQ. In the late 1980s, Flextronics diversified into disk and tape subsystems but the economic recession in the U.S. affected Flextronics’ revenue. As a result, in 1990, the company went private in a leveraged buyout, whereby its Asian plants were spun off. The new company was named Flextronics International and with its headquarters in Singapore.

In 1994, Flextronics went public a second time, with current Chairman Michael Marks assuming the CEO position. In the late 1990s, the company completed more than 12 acquisitions that include the Dii Group, Astron Group, nChip and FICO Plastics, and Flextronics expanded its square footage in low-cost geographies. Between 2000 and 2006, Flextronics acquired the OEM facilities of Alcatel; Xerox, and Nortel, and won contracts with Motorola and Siemens. In June 2007, Flextronics announced it would acquire its EMS industry competitor, Solectron, for $6.3B. The acquisition closed October 1, 2007, securing Flextronics’ position as the second largest EMS provider in the world.

Source: Deutsche Bank Equity Research, VentureOutsource.com