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Molex Inc’s earnings for the second quarter of fiscal 2013 beat the Zacks Consensus Estimate by a penny. Revenues also beat by a sliver. Shares dropped 2.9% during the day but did not move in after-market trading because of the disappointing guidance.

Revenue

Molex reported revenue of $967.7 million, which was up 5.5% sequentially and 12.8% year over year, exceeding management expectations of $930-970 million (up 1-6% sequentially).

Overall, infotech and telecom were clearly the high points, although automotive also improved. Molex’s gains in infotech speak for its position at key customers and products. Most other companies serving the market, such as Intel Corp (INTC - Analyst Report), Advanced Micro Devices (AMD - Analyst Report) and Texas Instruments (TXN - Analyst Report) have suffered.

Management stated that Europe was again very weak, declining 13% sequentially and 16% year over year.

Revenue by End Market

The Data or Infotech market (28% revenue share) remained the largest contributor to revenue, growing 9.5% and 31.6% from the previous and year-ago quarters, respectively. Molex continued to see strength in tablets that was supported by flattish server and growing storage revenues.

Management stated that although server revenue declined in the last quarter, units sales were on the rise. Molex had some wins in the server segment, 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 18.7% sequentially and 17.2% year over year to 27% of total revenue. Management did not say how the infrastructure side of the business did in the last quarter, but its optical routing and digital cross connect products position it well for 4G LTE build-outs.

Spending on this infrastructure has so far been mainly in North America, Japan and Korea; spending in the BRIC countries should not be too far off. The mobile phone business was strong as may be expected of a typical holiday season and Molex stated that new products also played a part.

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 16% of total revenue, flat sequentially and up 12.8% 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 remained 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 dropped 7.7% sequentially and 12.2% year over year to 14% of revenue. Continued weakness in TVs and digital cameras (that are being impacted by higher camera phone sales) were responsible for the softness. Management stated that Japan accounted for most of the decline.

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 11% of revenue, down 10.7% sequentially and 4.5% from last year. Management stated that customers including distributors were exercising extreme caution, particularly in Europe. The good news was that parts of North America and overall Asia did well. Around 65% of the company’s industrial revenue comes through distributors. The business typically reflects global GDP growth rates.

The remaining 4% of Molex’s revenue came from Medical/Military markets, which were up 40.7% sequentially and 50.5% year over year. Molex is building this business both internally and through acquisitions.

Orders

Total orders were down 2.5% sequentially and up 12.9% in the Dec quarter. As a result, backlog also softened, declining 10.4% sequentially while increasing 16.3% from last year. The book to bill dropped well below unity. The sequential decline was more or less in line with normal seasonality.

Approximately 27% of Molex’s total orders were from the data/ infotech market, 26% from telecom market, 17% from auto, 164 from consumer, 11% from industrial and 5% from medical/military. While the consumer, industrial and infotech markets declined in the last quarter, the decline in industrial was the greatest. Telecom and auto and medical/military were up 5.6%, 3.5% and 21.8%, respectively.

Margins

Molex reported a gross margin of 29.9%, up 61 basis points (bps) sequentially and down 78 bps year over year. The sequential improvement in the gross margin was on account of higher volumes. Molex’s costs are going up, particularly with respect to certain new applications and assemblies for the mobile segment. This is the main reason for the decline from last year.

Operating expenses of $181.0 million were up 11.0% from the previous quarter’s $163.1 million, with the operating margin shrinking 31 bps sequentially and 47 bps year over year to 11.2%.

Net Income

Molex’s pro forma net income was $72.0 million or 7.4% of revenue compared to $73.9 million or 8.1% of revenue in the Sep 2012 quarter and $66.7 million or 7.8% of revenue in the Dec 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 $70.4 million ($0.39 per share) compared to an income of $76.4 million ($0.43 per share) in the previous quarter and income of $64.0 million ($0.36 per share) in the year-ago quarter.

Balance Sheet

Inventories were up 0.4%, with inventory turns increasing from 4.6X to 4.8X. DSOs went from 77 to around 70.

Molex ended with a cash and short term investments balance of $716.8 million, up $14.7 million during the quarter. Cash generated from operations was $87.2 million, down from $167.4 million in the first quarter. Capital expenses were $78.6 million, or 8.1% of revenue, up from 7.6% of revenue in the previous quarter. Molex also paid $77.9 million for cash dividends in the last quarter.

Guidance

Molex expects revenue of $900-930 million in the next quarter, down 4-7% sequentially. The pro forma EPS (excluding a cent for unauthorized activities in Japan) is expected to be 33 to 37 cents a share, assuming a tax rate of 30-32%. The Zacks Consensus estimate for the third quarter of fiscal 2013 was 38 cents, below 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.

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.

Molex shares carry a Zacks Rank #3 (Hold).

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