Sanmina Corporation (SANM) Q3 2018 Earnings Report, Transcript and Summary

Good afternoon. My name is Erica and I will be your conference operator today. At this time, I would like to welcome everyone to Sanmina’s Third Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator instructions] Thank you. Ms. Paige Bombino, Vice President of Investor Relations, you may begin your conference.

Thank you, Erica. Good afternoon, ladies and gentlemen. And welcome to Sanmina’s third quarter fiscal year 2018 earnings call. A copy of our press release and slides for today’s discussion are available on our website at sanmina.com in the Investor Relations section. Joining me on today’s call is Bob Eulau, Chief Executive Officer; and Dave Anderson, Chief Financial Officer. Following their prepared remarks, we will open the call up for questions. Let me remind everybody that today’s call is being webcasted and recorded and will be available on our website. You can follow along with our prepared remarks in the slides provided on our website. During this conference call, we may make projections or other forward-looking statements regarding future events or the future financial performance of the company. We caution you that such statements are just projections. The Company’s actual results of operations may differ significantly as a result of various factors, including adverse changes to the key markets we target, significant uncertainties that can cause our future sales and net income to be variable, reliance on a small number of customers for a substantial portion of our sales, risks arising from our international operations, and other factors set forth in the Company’s annual and quarterly reports filed with the Securities and Exchange Commission. You’ll note in our press release and slides issued today that we have provided you with statements of operation for the quarter ended June 30, 2018, on a GAAP basis, as well as certain non-GAAP financial information. A reconciliation between the GAAP and non-GAAP financial information is also provided in the press release and slides posted on our website. In general, our non-GAAP information excludes restructuring costs, acquisition and integration costs, non-cash stock-based compensation expense, amortization expense, and certain other infrequent or unusual items to the extant material. Any comments we make on this call as it relates to the income statement measures will be directed at our non-GAAP financial results. Accordingly, unless otherwise stated in this conference call, when we refer to gross profit, gross margin, operating income, operating margin, taxes, net income, and earnings per share, we are referring you to our non-GAAP financial information. I would now like to turn the call over to Dave Anderson.

Thanks, Paige. Please turn to Slide 3. Revenue for the third quarter was significantly above our expectations coming in at $1.81 billion. Revenue was sequentially up 8.2% or $137.7 million and up 6% or $102 million from the third quarter of last year. This is a major milestone as we achieved our highest quarterly revenue since 2008 when we refined our strategy to focus on our customer’s mission-critical products, services and supply chain needs. Revenue was up across all of our end-markets on a sequential and year-over-year basis. Bob will be discussing our end-market performance in more detail in a few minutes. From a GAAP perspective, we reported net income of $34 million, which resulted in diluted earnings per share of $0.47 for the third quarter. This was up 40.8% sequentially and flat with Q3 of last year. As I pointed out during our Q2 earnings call, we recorded a reduction in our restructuring costs in the second quarter of $10 million, which was related to the reimbursement of severance and retention costs. In Q3, we recorded a $4.8 million reversal of an accrual for contingent consideration related to an acquisition that we previously completed that is no longer probable. We also separately recorded the discrete tax benefit of $4.8 million for the reversal of an accrual for a certain tax contingent fee that was settled during the quarter. Our remaining comments will focus on our non-GAAP financials for the third quarter. At $116.7 million, gross profit was basically flat with the prior quarter. Gross margin came in at 6.4%, which was a 60 basis point decline compared to the prior quarter. Gross margin was negatively impacted by unfavorable operating costs and inefficiencies that were associated with the ongoing supply-constrained environment as well as new program ramps. Operating expenses were $62.2 million, down $2.9 million from the prior quarter and below our expectation. As a percentage of sales, operating expenses were down 90 – 50 basis points to 3.4%, largely driven by lower incentive compensation, the containment of other operating expenses and a higher revenue base. At $54.5 million, operating income increased by 4.5% from the prior quarter and was down 23.7% from Q3 of last year. Operating margin was 3%, which was down 10 basis points from last quarter. Other income and expense of $5.8 million was better than our expectations and down $1.2 million when compared to last quarter and up $1.5 million from the third quarter of last year. The decline quarter-over-quarter resulted mainly from interest received on the collection of long outstanding receivable. The tax rate for the quarter was 18% of pretax income, which was in line with our expectations. We earned $39.9 million in net income with our non-GAAP EPS coming in at $0.55 for the quarter, which was below our expectations. Non-GAAP EPS was up 10.2% from Q2, but down 25.3% from Q3 of last year. This was based on 72.1 million shares outstanding on a fully diluted basis. Despite strong revenue for the quarter and the containment of our operating expenses, we were impacted by unfavorable operating costs and inefficiencies resulting from the ongoing supply-constrained environment and new program ramps. I will now discuss in more detail the factors impacting our non-GAAP EPS. Please turn to Slide 4, where we are providing information on the IMS and CPS segments. The Integrated Manufacturing Solutions segment represents printed circuit board assembly in test, final system assembly in test as well as direct order fulfillment. As you can see from the graph on the left, the IMS segment revenue was up $150 million from last quarter at $1.49 billion. However, our gross margin declined by 0.6 percentage points from Q2 to 5.7%. This gross margin decline was largely driven by unfavorable material costs, freight premiums and other inefficiencies associated with the ongoing supply constraints as well as new program ramp costs. On the right is our second segment: Components, Products and Services. Components include printed circuit board fabrication, backplane assemblies, cable assemblies, enclosures, precision machining and plastic injection molding. Products include: Computing and Storage products, Defense and Aerospace products, Memory and SSD modules as well as Optical and RF modules. Services include design and engineering as well as logistics and repair services. In aggregate, the revenue for this segment was up $29 million to $375 million, with gross margin down 0.7 percentage points from Q2 to 8.4%. The CPS segment gross margin was negatively impacted by a sequential decline in the Products and Services businesses that was partially offset by sequential improvement in the gross margins in our Components business. The Components improvement was largely due to better-than-expected results from the ramp down of our Owego plant. We completed the Owego closure in early July, and we expect cost savings of $2 million to $3 million in Q4. On Slide 5, we are showing you key non-GAAP P&L metrics. Revenue was up 8.2% from last quarter and up 6% compared to Q3 of last year. Gross profit was basically flat with last quarter at $117 million. Gross margin at 6.4% was down 60 basis points from last quarter. Our operating profit increased 4.5% from last quarter to $54.5 million, and this led to operating margin of 3% and non-GAAP EPS of $0.55. As we have stated on prior calls, we continue to be impacted by a challenging supply environment. The supply challenges are creating inefficiencies in our plans and increasing our operational costs that are creating downward pressure on our profit. In Q3, our sales operations and supply chain team did a great job in resolving a number of the supply chain constraints that allowed us to ship record revenue for the quarter. However, we incurred extra cost in Q3 to satisfy our customers’ requirements. We expect our gross margins to recover in Q4 as we work with our customers to recoup these incremental costs. I’d now like to turn your attention to the balance sheet on slide number 6. Our cash and cash equivalents were $405 million. Cash was flat with the previous quarter, accounts receivable was up $66 million and inventory was up $65 million. We will talk more about inventory in a moment. From a liability standpoint, we had an increase of $125 million in accounts payable during the quarter. This was in line with the increase in revenue. Our short-term debt was up $367 million from last quarter as our long-term debt of $375 million, that is due in June of 2019, is now classified as current. We repurchased $28.9 million worth of common shares and specifically, we repurchased approximately 962,000 shares at an average share price of $30.01. As of the end of the quarter, we had $15 million in long-term debt and our gross leverage was approximately 1.9 based on our total debt. We strengthened our liquidity in Q2, but the renewal and upsizing of our credit facility, and we are assessing our options for the refinancing over the $375 million in debt that is due in June of 2019. Overall, our balance sheet and capital structure remain in great shape. Please turn to Slide 7, where we will review our balance sheet metrics for the third quarter. Cash was very consistent with prior quarters. Cash flow from operations for the quarter was positive at $61.8 million, and net capital expenditures for the quarter were $22.6 million, which ran under our expectations as we continue to drive the optimization of our existing facilities and equipment. This led to positive free cash flow of $39.1 million, an increase of $35.9 million over Q2. While we are pleased that we once again generated positive free cash flow for the quarter, we are still not satisfied with our progress in reducing our inventory. Inventory dollars were up in Q3 by $65 million, ending the quarter at $1.19 billion, with inventory turns coming in at 5.9, up 0.2 return from Q2. Although lead times on parts of started to somewhat stabilized, inventory turns continue to be a challenge, largely driven by ongoing material shortages on certain commodities, such as resistors, capacitors and discrete semiconductors. In Q3 2018, we saw the number of parts with lead times over 81 days start to level off moving from 35% to 33%. We are seeing component manufacturers adding capacity, but not at a rate in line with industry demand and suppliers are still generally reluctant to increase capacity for older component technologies. Some component manufacturers continue to indicate that certain component constraints will continue to the second half of calendar 2018 and possibly further, depending on the commodity. We continue to work closely with our customers to maximize the fulfillment of their demand, while also working on addressing our elevated inventory levels. In the lower left quadrant, we are showing cash cycle days, which combines our cycle time for inventory, accounts receivable and accounts payable. Overall, despite the continued impact of the supply constraints on our inventory, cash cycle time decreased from 51.1 days last quarter to 48.5 days, a 2.6-day improvement. This change was mainly driven by a decrease in our accounts receivable days sales outstanding and inventory days. Finally, pretax ROIC increased by 40 basis points from the prior quarter to 16.2%. Please turn to Slide 8. I would now like to share with you our guidance for the fourth quarter of fiscal 2018. Our view is that revenue will be in the range of $1.825 billion to $1.875 billion. On a non-GAAP basis, we expect that gross margin will be in the range of 6.9% to 7.3%. Operating expense should be $65 million or $67 million. This leads to an operating margin in the range of 3.3% to 3.7%. We expect that other income and expense will be in the range of $7 million to $8 million. Our tax rate should still be continue to be around 18%, and we expect our fully diluted share count to be around 71 million shares, plus or minus 0.5 million shares. When you consider all of this guidance, we believe that we will end up with non-GAAP earnings per share in the range of $0.63 to $0.69. Finally, for your cash flow modeling, we expect that capital expenditures will be around $35 million. Net capital expenditures for the full fiscal year, based on our expectation for the fourth quarter, should be in the range of $125 million to $130 million. Depreciation and amortization for the fourth quarter will be around $30 million. Revenue for the quarter was a record and is expected to be up again in our fourth quarter, driven by strong demand from our existing and new programs. While profit is not yet meeting our expectations, we continue to work on initiatives to optimize our cost structure and drive operational improvements across our entire organization. As we said during our Q2 earnings call and at our Investor Day in May, the second half of the year would be stronger than the first half from a revenue, gross margin and cash flow perspective. We still expect this to be the case. We are working with our customers to manage through this challenging supply environment and expect to close fiscal 2018 on a strong note from a revenue, gross margin and cash flow perspective. And now, I would like to turn the discussion back over to Bob for more comments on our target markets and our overall business priorities.

Thanks, Dave, and good afternoon, everyone. At a high level, revenue for the third quarter came in much better than we expected at $1.81 billion, driven by strong demand across all of our end-markets. I’m very pleased with the work our team did, getting material in a very difficult supply chain environment. Despite strong revenue, profitability was negatively impacted by inefficiencies associated with this difficult supply-constrained environment and ongoing new program ramps. As Dave mentioned, I expect very thought profitability improvement in the fourth quarter. Please turn to Slide 10, as I would like to provide a few additional comments on our end-markets for the third quarter. As a reminder, at our Analyst Day in May, we provided you with our new end-market breakdown. Communications Networks was 37.1% of revenue or $673 million, up 4.8% sequentially and up 0.5% from the same period a year ago. Optical continues to be the largest portion of the Communications segment. Optical was up high single-digit sequentially. Year-to-date, Communications is up 3% over the prior year. Industrial, Automotive and Defense was 35% of our revenue or $634 million, up 7% sequentially and up 3.5% from the third quarter last year. Industrial, Auto and Defense were each up sequentially. Automotive being the biggest driver as new programs are shipping, although still not at the level we had expected at this point in time. Year-to-date, this whole segment is flat with the prior year. Growth is starting to accelerate, but the acceleration is later than we had anticipated. Medical was 16.6% of revenue or $302 million. This segment was up 12.7% sequentially and up 29.8% year-over-year. Growth in this segment is attributed to the combination of new programs ramping and demand from existing programs. Medical products have a long sales cycle, a long qualification cycle and fortunately, a long product life cycle. We are realizing the benefits of programs with one or couple of years ago. Medical is up 18.2% on a year-to-date basis versus the prior year. Cloud solutions consist of cloud computing, storage system, point of sales, devices, casino gaming and setup boxes. This segment was 11.3% of revenue or $204 million. This segment was up 18.2% sequentially and up 4.2% year-over-year. We saw a strong demand from our storage systems and cloud computing businesses. Year-to-date, this segment is down 10.6%. We started small shipments this quarter to a Tier 1 Cloud Service Provider. In the third quarter, our top 10 customers represented 52% of revenue, and we have one customer that was greater than 10% of revenue. Please turn to Slide 11. I’d now like to discuss our outlook for the fourth quarter by end-market. For Communications Networks, we expect to be down slightly. We have the demand, which will drive growth, but we have to solve some critical material shortages in order to grow. The Industrial, Automotive and Defense segment, we expect to be up sequentially for the fourth quarter. We expect growth in all three areas. We expect this segment to be up year-over-year for the full year. We are forecasting Medical to be up sequentially. We are seeing solid demand from programs we won 12 to 24 months ago that are now ramping. We expect the Medical segment to be up year-over-year for the full year. For Cloud solutions, we are forecasting this market to be up sequentially. For the full fiscal year, we expect this segment to be down, though we are having nice growth in our cloud and storage business in the second half of fiscal 2018, it will not offset this low in first half of the year. Revenues should improve again in the fourth quarter and we’re excited about the future of this segment. Please turn to Slide 12. In summary, the third quarter of fiscal 2018 was strong from a revenue standpoint, but disappointing from a margin perspective. As we said on our call in April, we expected the second half of fiscal 2018 to be stronger than the first and this is playing out as we expected. We’re making good progress on new program ramps, but not as quickly as I would have liked. Our capacity utilization will continue to improve. Access to critical components continues to be a challenge, but our team is focused on the gating items so we can build more and ship more. We still have a lot of work to do, and we’re not satisfied with where we are today. Now I will make a few comments on the fourth quarter. We are excited about the new programs we have won and continue to win. The pipeline of new business opportunities remain strong. I’m confident in our team’s ability to grow revenue sequentially and year-over-year. I expect profit to improve as we continue to reduce our costs and inefficiencies and better utilize the capacity we have put into place. We will start to see the benefit of restructuring this quarter as well. Our long-term strategy is unchanged. We continue to win new business and diversify our customer base with a focus on mission-critical products where we provide more value to our customers. The pipeline of potential opportunities is very robust. I want to thank our employees for their hard work and dedication. We have won a number of new programs and this is a testament to Sanmina’s value proposition and our ability to execute. Thank you for your continued interest in Sanmina. And operator, we would now like to open the line for questions.

[Operator Instructions] Your first question comes from Ruplu Bhattacharya from Bank of America.

Hi, Ruplu.

Hi, thanks for taking my question. Hi, Bob, how are you?

Hi, Ruplu.

Just maybe to start off with you saw a stronger than expected revenues from the Communications segment. So if you can just talk about Optical, Wireless, Networking, what was the area that you saw strength in? And I think you also mentioned that this was an area that is being impacted by component shortages, so if you can talk a little bit about that?

Yes, happy to do that. And as you noted, I mean, we’re pleased with Communications was up about 4.8% sequentially and up a little bit year-over-year. Optical continues to be strong. I think I said in my comments it was high single digits. The breakout on the other two segments, I don’t have right in front of me, but for the subsegments I should say, but I would say wireless continues to be challenging, and we are starting to see some good movements in terms of Networking business.

Okay, that’s helpful. And then just on the margin improvement. I think you’re guiding sequentially about 70 basis points improvement in gross margin for the fourth quarter. So maybe just to highlight for us some of the things that give you confidence that despite the challenges you are having that you can have that margin improvement.

Yes. I think we’re definitely making solid progress in terms of new program ramps, and I think we’re getting more efficient in terms of how we’re bringing materially and how we had – we’re taking in smaller shipments than we were before, which was impacting our cost structure. We were in smaller production runs than what we have been doing historically, which was hurting our efficiencies as well. And we think that in the fourth quarter we will have a good mix of business as well.

All right. Last one from me. Did you also say that you were able to pass on the Component costs or are you trying to pass on the Component costs to your end customers and similarly for the freight cost? So is that something you can recoup into the fourth quarter?

Actually, Ruplu, it’s Dave. Yes, we’ve been working through that, and we normally try to work pass that on, and we reflected some of that in our guidance for Q4.

Okay, great. Thank you so much. Appreciate the color.

Thank you, Ruplu.

And your next question comes from Sean Hannan from Needham & Company.

Hi, Sean.

Good evening, folks. Thanks for taking the question here. So I want to talk around the Component topic as well as, I think Bob you just touched on this a moment ago in terms of referencing some of the inefficiencies and the yield that you had as an issues in some prior quarters. So just trying to get a sense of, when we look at the performance you had in this June quarter, can you give us a sense of the drag that was perhaps more attributable one versus the other components inefficiencies yields and to what degree, as we get to a better margin outlook into next quarter? Are we factoring some of those variables and how are we thinking of that moving forward?

Okay. I think you had several points in there. So first thing I want to clarify is I did not comment on yield and yields are up significantly from where we were at the beginning of the year. So we still obviously always have room to improve on yields, but the rate of change in terms of designs has really slowed down, and I would say that the yields have been significantly better. Now it doesn’t mean that we still don’t have issues with the lines going down really across the board, across factories around the world as well as across the various end-market segment. So when we go lying down, that’s very painful for us because we’ve been unable to observe a fixed cost that we have in place. So that’s probably the biggest issue that we’re dealing with right now, and we expect, again, that more efficient on an ongoing basis as we move forward.

Okay. And so when those lines are coming down, you see the driver behind that – I’m sorry I’m not sure if I had followed more of the external factor in terms of having a wait up for additional components or what are – what’s driving that there?

Now thank you for clarifying, Sean. I should have said that. I was really referring to the component availability. As you know, we can have – there are thousand parts on to build a product and we have 999, we can’t build, so the line comes down and we’re very inefficient. And so that makes us inefficient from a operating cost standpoint and its also a key contributor to our inventory being high right now.

Okay. And so, while operationally, you’re improving a lot of inefficiencies, I think you addressed that in the last question. To what degree do we have then incremental factors tie to where there could be a component impact next quarter? It sounds – it sounded in a way your color commentary was almost indicating a little bit more stability versus where you were previously in this whole topic of component tightness, whereas some others competitors are kind of increasingly talking to that environment. So just trying to connect all the dots here and try to understand how does that factor into that September guidance?

Yes. So they made some comments, and we actually do think that things have stabilized a bit. Having said that, I mean, lead times are still very long. So I think it’s roughly 1/3 of our parts of lead times over 81 days. Now if the lead times are accurate in our systems, then we will be able to operate much more efficiently. The big challenge is when the lead times are changing on us or when suppliers aren’t meeting their commitments and then we end up getting surprised by it when we actually receive the material. So I think there are, again, relatively more stable, although with long lead times, and we should be able to operate more efficiently that way.

Okay. Thanks for taking a lot of those variations on the Components topic. Just last one here and I will hop back in the queue. You had commented Bob, Automotive making good progress there, but still not really at the levels that you had, I think previously expected to be at this point in time. Just wanted to get clarification around that, is that a factor of demand from your customers or is this also tying back into this very same topic of Components free and other factors in the production there?

Yes. As I mentioned actually at our analyst meeting and I said before on this call, we’re super excited about Automotive. I think we’re really well positioned for that particular type of business. We really diversified our offerings within the Automotive segment. And so we – it’s an area where we have a number of program wins, and we’ve been ramping the revenues actually grown a lot year-over-year, but we are expected to grow even more by this point in time and I believe we will see very good growth in Automotive next year as well. So it’s definitely impacted by supply chain, and it’s impacted in some cases by design, but we’re definitely working our way through that. We’re seeing yields up significantly and some of the Automotive programs. So I think we’re in a good place in getting better with Automotive.

Okay. So it’s in that correction of some of the yields other factors in there – this I think a lot of times can be some at least a little bit of a better margin and is that providing in some of the optimism in that bump quarter-on-quarter in that gross margin?

Yes. It’s certainly an area we’re optimistic, but as I mentioned I mean, will seeing growth in almost across the board, so I think that will help.

Okay. Thanks so much. Thanks for your patience here.

Thank you, Sean.

Your next question comes from Christian Schwab from Craig-Hallum Capital.

Hey, great. Thanks for taking my questions. Great quarter in a difficult component environment. Bob, is there any way to quantify what the negative top line impact is in the second half of the year due to component constraints?

I think it’s really difficult to say. I mean, I think we obviously did much better in the third quarter than we had anticipated at the beginning of the quarter, because we were able to get Components. I can tell you the demand is still very strong. I mean, if we can get the parts, I mean, we can ship even more than what we’ve indicated. So it’s very much around material availability right now.

Okay. So we kind of talk about maybe some of these component constraints continuing through 2018 maybe into 2019. If we think out a little bit longer than a quarter or so and we talk about new program ramps kind of being behind us, component constraints being behind us and our utilization rates being optimal, again, as you go forward exiting this year or exiting March of next year, not to put time frame on it for you, should there be any reason that we don’t like return back to the gross margins that we saw back in 2016 and approach to high 7s, low 5 range?

Yes. I don’t want to give this guidance beyond what we’re giving for next quarter, given you describe it very hypothetical environment, but there is no doubt that we can do significantly better in terms of gross margin if we work our way through this environment, and we got a very good demand, we got a great mix of business, and I think in this environment our team has done a very good job in terms of getting material, and I think we’ve got momentum to do much better in terms of margins.

And Christian, I would say that we’ve talked about at the Investor Day in May that the targets that we’ve put out there is still what we driving for.

Right. On the operating margin standpoint, correct.

Correct.

All right. That makes perfect sense. No other questions. Thank you.

All right, thanks Christian. So we have time for one more question.

Your last question comes from Mitch Steves from RBC Capital Market.

Hi, thanks for taking my question. So mine is actually more the margin front, and I’m just trying to get a better handle to component issues. So is there a way to think about from a margin perspective in terms of what the impact was this quarter? And then maybe going forward as well in terms of the component shortages versus the new program ramps?

Well, it’s very hard to tease apart all those different crosscurrents. I mean, there is no doubt of the component situation makes us less efficient than we have, otherwise would be. If things get stable even what long lead times, I think we can have our margins improved pretty significantly and then over time, we’ll just continue to get more and more efficient as I had mentioned before, we’re still underutilize some of our capacity so as we utilize more of that capacity that will improve our margins as well.

Got it. And then just one quick follow-up on the medical side of 30% growth seems pretty outsized, is there any specific to fly and that happening to the quarter? That may not reoccur in the future?

Well, year-over-year I was almost 30%. I think that year-over-year was still going to benefit from competitors that are beneficial to us. We’re still seeing quite strength in medical. I think we will, I think I said we will see more sequential growth this quarter in terms of Medical. So I think and again as far as I noted in my comments, it’s a long sales cycle, long qualification cycle and are really starting to benefit and at this point it’s just a question of our customer success in the market, because we won a number of programs.

Understood. Thank you.

All right. Thank you, Mitch, and thanks everybody. We really appreciate you joining us today and look forward to seeing you in the future.

Thanks to everyone.

Thank you. This does conclude today’s conference call. You may now disconnect.