It’s been a little bit more than six months since the publication of our initial bull thesis on Flextronics International Ltd. (NASDAQ:FLEX), and its time to review the position. The green arrow on the chart below shows the date of publication, and the price movement since:
Quick Review of Initial Thesis
In our initial report, we focused on Flextronics’ extremely cheap valuation, recent company insider buying, and its strong price momentum. The company was also a free cash flow machine, and had a history of rewarding shareholders with share buybacks. Stocks that have these factors have historically generated significant alpha.
Since the article was published on January 24th, Flextronics stock price has moved from $11.04 to a high of $12.86, before falling right back to $11.02. The rise in Flextronics stock price from February to April was likely due to a post-earnings announcement drift effect stemming from the company’s solid Q3 earnings release. Flextronics beat the Q3 EPS consensus by 12.5% ($0.27 versus estimates of $0.24) and beat consensus revenue estimates by 6%. Flextronics followed this up by beating the Q4 consensus EPS estimates, though the stock then missed Q1 EPS consensus estimates.
While headline results have been disappointing recently, Flextronics continues to make progress in its transition towards higher margin segments:
High reliability solutions [HRS] and and Industrial & Emerging industries [IEI] jumped to 36% of revenue this quarter, up from 30% last year.
Both these segments have (or at least projected to have) much higher operating margins than the core consumer technology [CTG] and integrated network solutions [INS] segments:
The ranges presented for each segment reflect what management projected operating margins to be, while the blue peg represents what they actually were. As you can see in the orange IEI scale, operating margins were way below projections at 2.6% (versus a projected range of 4% to 6%).
Thesis Moving Forward
We’ll remind investors that we are quants who sift through academic papers and historical data to find repeatable patterns that can be exploited for profit. We’ve distilled our insights into an equity-pricing model that seeks to use historical back testing to generate 12-month price targets that are more accurate than the Wall Street consensus.
Our core thesis remains from our initial report, as we believe there is still significant upside available in Flextronics. The stock remains extremely cheap from a relative standpoint. The chart below shows how Flextronics ranks versus the market on five common valuation metrics:
With trailing twelve-month sales of $25.1 billion and a market cap of $6.17 billion, Flextronics currently sports a sales yield of 406% ($25.1/$6.17). This puts it in the 95th percentile of all stocks in the market ranked by sales yield.
Historical back testing shows that stocks ranked within the 90th to 99th percentile (i.e. top 10%) of the market by sales yield have historically beaten the market by 4.11% a year, on average:
Flextronics is also severely undervalued from an earnings and free cash flow basis. The stock’s 8.7% earnings yield and 25% free cash flow yield are ranked in the 88th and 82nd percentile of the market, respectively.
Stocks ranked in the 80th to 89th percentile of the market based on earnings yield have historically outperformed the market by 4.06% a year on average:
Stocks ranked in the 80th to 89th percentile of the market based on free cash flow yield have beaten the market by 2.7% a year, on average:
It’s clear that history favors Flextronics position right now, as the market has consistently rewarded investors of cheap stocks with significant alpha. This is because cheap stocks are either embarrassing to hold or are part of boring industries with little “excitement”.
Flextronics fits into the latter category, as the contract manufacturing industry is far removed from the excitement surrounding their branded customers. Over time, this inefficiency will correct itself as it always does and investors should expect Flextronics to be a major beneficiary.
Next, we’ll analyze Flextronics’ price momentum, growth, and profitability profile. Again, we’ll look to the past to see how stocks in similar situations have historically performed. The chart below ranks Flextronics on five different growth metrics within the market:
Flextronics momentum has slowed recently, with the stock price falling 2.7% over the last six months and gaining a mere 5.7% over the last twelve. In both metrics, Flextronics falls near the middle of the market and shouldn’t materially impact returns moving forward. Earnings have grown 12% over the last 12 months compared to the same period a year ago, which is more than double the median of the market.
The one metric that is impressive in the chart above is the company’s 22.4% return on equity. This is more than double the median stock’s ROE in the market, and puts it in the 84th percentile of the market ranked on ROE. Historical back testing shows that stocks ranked within the 80th to 89th percentile of the market by ROE have historically beaten the market by 1.58% a year, on average:
Unlike value, we don’t expect Flextronics growth profile to contribute significant alpha moving forward. With that being said, considering Flextronics extremely cheap valuation, it is noteworthy that the company is highly profitable and growing earnings at all.
Next, we’ll analyze Flextronics sentiment profile, looking at how the “smart money” (i.e. short sellers, institutions, and company insiders) is trading the stock. These investors tend to have an informational advantage over the average market participant and their transactions often foreshadow future movements in price.
Of the three metrics listed above, the short interest ratio is by far the most important. This is due to new regulations that decrease the ability of insiders to profit from illegal insider information. Institutional transactions are also important, but they tend to be stale as they are only released once quarter (versus the timelier bi-weekly short interest report).
Thus, while it is slightly discouraging that Flextronics company insiders have been dumping stock recently, investors should pay more heed to the stock’s extremely low short interest ratio. This disparity in metric importance is reflected in the historical backtests.
Stocks ranked in the 70th to 79th percentile of the market based on short interest have beaten the market by 2.45% a year, on average:
While stocks that are ranked in the 0th to 9th percentile of the market based on company insider transactions (i.e. the 10% of stocks experiencing the greatest decrease in company insider ownership change) have historically underperformed the market by 1.88% a year, on average:
Similar to its growth, we don’t expect Flextronics sentiment profile to meaningfully contribute alpha moving forward.
This brings us to our projected 12-month price targets. Our equity pricing model use historical back testing to predict the amount of “excess returns” (i.e alpha) a stock will generate. It combines this with the stock’s beta to project a range of 12-month target prices. This range is expected to have a 75% area of accuracy (i.e. the stock price will be within the price range 75% of the time). These projections are shown below:
On our base case, the Quantified Alpha algorithms expect Flextronics to rise from its current price of $10.89 to $12.94 over the next twelve months. This represents upside of 19.20% from current prices.
Our algorithms project a 75% probability that Flextronics stock price will be between $10.24 to $15.72 in 12 months. This ranges from potential downside of -5.98% to potential upside of +44.36%. Risk-reward looks skewed to the upside.
These are slightly more optimistic projections than Wall Street analysts, who currently have an average 12-month price target of $12.24 (representing upside of 12.4% from current prices).
Flextronics has historically experienced low levels of price volatility. This means that Flextronics options tend to be overly cheap. When buying calls, we focus on long-term in-the-money options. They tend to have high proportions of intrinsic value relative to time value priced into the options. This allows investors to benefit from the leverage inherent within options, while avoiding the speculative nature of out-of-the-money options.
In particular, we think the January 15th $10 and $11 call options look attractive. The $10 options were last traded for $1.45, which means that investors just need a $0.45 move (4.1% gain) from now till the expiry date to break even on the trade. The $11 options are a bit more speculative, as they last traded at $0.75. This means investors would need a 6.2% upside move from now till expiry to break even on the trade.
We advise investors to buy into Flextronics – whether through equity or long-term call options – during the stock’s recent dip in price as it affords a rare opportunity to generate significant alpha.
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