Flex (FLEX, Financial) is undergoing a business transformation that should result in structurally higher returns on invested capital. A decade ago, the company, then known as Flextronics, looked like a classic contract manufacturer. Like its peers, it had a concentrated customer base, composed almost entirely of electronics companies, and it would manufacture products to meet customer specifications. Contract manufacturers have few meaningful competitive advantages in the low-margin manufacturing business, as their main value-add is locating production in low-cost regions. However, since Mike McNamara took over as CEO in 2006, Flex has been investing in what it calls “sketch-to-scale” capabilities, in which Flex’s engineers are actually involved in the design phase of customers’ products. This is a better business than contract manufacturing due to higher barriers to entry, stickier customer relationships and higher profit margins. Sketch-to-scale arrangements account for about 23% of revenues today and should almost double to 40% by 2020. In our view, this business shift and the accompanying boosts to both margin and ROIC are not priced into the stock, which trades for less than 14x next year’s consensus EPS after adding back intangible amortization.
From Bill Nygren (Trades, Portfolio)'s first quarter 2018 Oakmark Fund commentary.
