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Molex Inc’s earnings for the first quarter of fiscal 2013 were in line with the Zacks Consensus Estimate of 40 cents. Revenues were just short of expectations.

Revenue

Molex reported revenue of $916.9 million, which was up 6.8% sequentially and down 2.0% year over year, missing management expectations of $900-940 million (up 5-10% sequentially). Revenue was also short of the consensus expectation of around $920.0 million. The sequential increase was encouraging, while the decline from last year was due to over-ordering in that quarter.

Overall, revenue from the industrial market continued to weaken, while Infotech and telecom strengthened. Molex was impacted by weakness in industrial and telecom infrastructure, similar to what Texas Instruments (TXN - Analyst Report) reported earlier. The tablet strength it saw was similar to that mentioned by others like Intel (INTC - Analyst Report) and Advanced Micro Devices (AMD - Analyst Report). Therefore, there were few surprises in the quarter.

Management stated that Molex saw pockets of strength in the U.S. and Asia and significant weakness in Europe, which was down 13% sequentially and 16% year over year.

Revenue by End Market

The Data or Infotech market (27% revenue share) remained the largest contributor to revenue, growing 10.9% and 1.7% from the previous and year-ago quarters, respectively. Molex continued to see strength in tablets that was supported by a flattish server and storage business.

Management stated that the broader market for both peripherals and server and storage segments continued to weaken, although Molex had some wins, which helped it gain market share and generate relatively steady revenue.

Longer-term drivers in this market continue to be the migration to SAAS 2.0 and 16GB fiber channel networks in the storage market, as well as the popularity of tablets and other MIDs. The transition from copper to fiber-optic platforms will also drive results, as Molex remains well-positioned with solutions for this market.

Telecommunications stayed in the second place, increasing 16.5% sequentially and 2.2% year over year to 24% of total revenue. Strength on the mobile phone side, where Molex’s new products were particularly strong offset weakness on the infrastructure side of the business.

Management currently expects a repeat of the situation in the next quarter, as its new products for mobile phones continue to ramp and infrastructure remains weak. The infrastructure business is currently expected to  pick up thereafter.

The long-term drivers for mobile phones are the growing adoption of smartphones and the continued cramming of features into increasingly smaller devices. Secular drivers of the infrastructure business include increased Internet usage, increased volumes of mobile devices of various kinds, more video being watched and transmitted, as well as the adoption of cloud computing.

The automotive market brought in 17% of total revenue, up 0.9% sequentially and 11.0% from the year-ago quarter. Molex is seeing normal seasonal trends in this business, as well as increased design activity and project wins. The growing adoption of standard devices in Asia is a positive in terms of profitability. Safety and infotainment were the strongest areas in the last quarter.

The increasing electronic content for safety systems, powertrain, infotainment and telematics in automobiles is a long-term positive because it expands the market for Molex’s connector technology. This and Molex’s exposure to China (where a large amount of auto manufacturing has shifted) are secular drivers of demand in this market.

Consumer Electronics grew 0.5% sequentially while declining 21.6% year over year to 16% of revenue. The sequential performance was the combined result of a strong gaming business that offset weakness in other areas, particularly TVs and digital cameras. Management currently expects protracted weakness in TVs and digital cameras due to a smaller build for the holiday season.

Molex should do well longer-term, as its customers introduce new products targeting the BRIC countries, as well as Vietnam and Thailand, where growth is expected to be stronger than in other parts of the world. Higher disposable income and increased consumerism in developing countries are secular drivers of demand in this market.

Industrial generated 13% of revenue, down 0.8% sequentially and 2.0% from last year. Management stated that customers including distributors were exercising extreme caution, particularly in Europe. Around 65% of the company’s industrial revenue comes through distributors. The business typically reflects global GDP growth rates.

The remaining 3% of Molex’s revenue came from medical/military markets, which were up 6.8% sequentially and down 2.0% year over year. Molex is building this business both internally and through acquisitions, which management stated would remain a focus area for Molex.

Orders

Total orders were up 4.8% sequentially and 3.7% in the September quarter. However, backlog strengthened for the second straight quarter, growing 6.2% sequentially and 15.8% from last year. The book to bill dropped slightly to 1.03, positive for the third straight quarter. Order growth was driven by new products and is indicative of a strengthening business for Molex, which is a big positive given the current macro uncertainty.

Approximately 27% of Molex’s total orders were from the data/ infotech market, 26% from telecom market, 16% from auto, 16% from consumer, 12% from industrial and 3% from medical/military. While the consumer, industrial and automotive markets declined in the last quarter, the decline in industrial was the greatest while the declines in the other two were about even. Telecom and Infotech were up 13.5% and 8.8%, respectively while medical/military were up mid-single-digits.

Molex did not provide any insight into the breakup by OEM/distribution/EMS.

Margins

Molex reported a gross margin of 29.3%, down 73 basis points (bps) sequentially and 200 bps year over year. The margin was impacted by startup costs related to new products a negative mix of business.

Operating expenses of $163.1 million were up 1.0% from the previous quarter’s $161.6 million, with the operating margin expanding 30 bps sequentially, while shrinking 171 bps year over year to 11.5%.

Net Income

Molex’s pro forma net income was $73.9 million or 8.1% of revenue compared to $75.1 million or 8.7% of revenue in the June 2012 quarter and $83.4 million or 8.9% of revenue in the September quarter of 2011. Our pro forma estimate for the last quarter excludes losses related to unauthorized operations in Japan.

Including the special item, Molex reported a GAAP net income of $71.3 million ($0.40 per share) compared to an income of $72.0 million ($0.40 per share) in the previous quarter and income of $80.5 million ($0.46 per share) in the year-ago quarter.

Balance Sheet

Inventories were up 6.1%, with inventory turns increasing from 4.5X to 4.6X. DSOs went from 80 to around 77.

Molex ended with a cash and short term investments balance of $702.1million, up $49.8 million during the quarter. Cash generated from operations was $167.4 million, up from $143.3 million in the fourth quarter of fiscal 2012. Capital expenses were $69.4 million, or 7.6% of revenue, down from 9.1% of revenue in the previous quarter. The significantly higher capex in the previous quarter is related to new products being introduced. Molex also paid $38.8 million for cash dividends in the last quarter.

Guidance

Molex expects revenue of $930-970 million in the next quarter, up 1-6% sequentially. The pro forma EPS (excluding a cent for unauthorized activities in Japan) is expected to be 36 to 40 cents a share, assuming a tax rate of 32%. The Zacks Consensus estimate for the second quarter of fiscal 2013 was 39 cents, within the guided range.

Conclusion

Molex is a leading player in the fast-growing connector market, with several secular growth drivers. However, the company appears to be seeing more growth in lower-margin segments, which is impacting its profitability. Additionally, macro conditions in Europe are impacting results, and the negative effect may be expected to continue in the next few quarters. The Zacks Rank for Molex shares is therefore #4, indicating a Sell recommendation in the short term (1-3 months).

A few other factors need to be considered for the long term. For instance, the nature of the business necessarily leads to some commoditization, which in turn results in price erosion.

New product launches by customers and the evolving nature of the served markets are offsetting positives that Molex should be able to take advantage of given its market position. Therefore, our long-term (3-6 month) recommendation on the shares remains Neutral.

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