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Molex Inc’s earnings for the third quarter of fiscal 2013 missed the Zacks Consensus Estimate by 3 cents, or 7.3%. The company has significant exposure to the computing and consumer markets, so expectations were low going into the earnings announcement. Molex’s quarterly results reflected market concerns, so shares didn’t move much in after-hours trading.

Revenue

Molex reported revenue of $852.9 million, which was down 11.9% sequentially and up 1.9% year over year, short of management expectations of $900-930 million (down 4-7% sequentially).

The weakness in consumer and computing markets that impacted companies like Intel (INTC - Analyst Report), Microsoft (MSFT - Analyst Report) and Texas Instruments (TXN - Analyst Report), also hurt Molex in the last quarter. Additionally, Molex had to contend with inventory corrections at a customer and the impact of orders that were pulled into the Dec quarter, which negatively impacted the sequential comparison. Since these markets generate roughly half of Molex’s revenue, the company’s top line missed expectations.

Both the Americas and Europe were up from the Dec quarter, with the Asia/Pacific declining double-digits. While the Chinese New Year was partly to blame, significant reduction in component inventories for mobile phones and tablets were also a major factor. The strength in the Americas and Europe was driven primarily by the automotive end market.

Revenue by End Market

The automotive market generated 20% of quarterly sales, making it the largest contributor. Segment revenue was up 10.2% sequentially and 13.4% year over year, helped by growing electronic content, increasing design wins and increasing automobile production. The softness in Asia is festival-related and not expected to continue since Molex saw orders increasing. The growing adoption of standard devices in Asia is a positive in terms of profitability.

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.

The newly-formed mobile device market was the second largest segment at 19% of revenue. Management has taken all mobile device-related revenue (tablets, mobile phones, smart phones and others from other segments to form this growing segment). Accordingly, the end market presentation of revenue and orders for prior periods has been restated. This end market was impacted by seasonality, order pull-ins into the Dec quarter and inventory corrections at a major customer, which resulted in a 37.0% sequential decline. Revenue was still 35.3% higher than the year-ago level.

Increasing smartphone production, growing opportunities in connectors and antennas and Molex’s strong position at all of the industry leaders are longer-term positives.

The Infotech market (17% revenue share) declined 6.2% and 9.6% from the previous and year-ago quarters, respectively. The decline was broad-based across service, storage, high-end PC and peripheral devices. Management stated that the Chinese New Year resulted in some seasonal softness as well.

Telecommunications, at 13% of revenue, was down 7.1% sequentially and 9.4% from last year. 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 in China. Spending on this infrastructure has so far been mainly in North America, Japan and Korea.

Secular drivers of the telecom 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.

Consumer Electronics dropped 16.8% sequentially and 18.8% year over year to 13% of revenue. Continued weakness in TVs, gaming and digital cameras (that are being impacted by increased demand for camera phones) were responsible for the softness.

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. The devaluation of the Yen should also help this year.

Industrial accounted for another 13% of revenue, up 6.3% sequentially and down 4.6% from last year. The cautiousness of previous quarters continued in the last quarter although order rates started improving, particularly in energy and semi test segments. Government and factory automation looks the weakest. Around 65% of the company’s industrial revenue comes through distributors. The business typically reflects global GDP growth rates.

The remaining 5% of Molex’s revenue came from medical/military markets, which were up 1.5% sequentially and 34.8% year over year. The strength in the last quarter is attributable to the Affinity Medical acquisition.

Orders

Total orders were down 1.1% sequentially and up 4.2% from the Dec quarter. As a result, backlog strengthened, increasing 13.6% sequentially while increasing 19.9% from last year. The book to bill went up sharply to well over 1.07.

Approximately 21% of Molex’s total orders came from the mobile devices segment, 19% from the auto market, 17% from the data/ infotech market, 14% from industrial, 13% from consumer, 12% from telecom and 4% from medical/military. While the mobile device, consumer and medical/military dropped 18.9%, 5.9% and 7.6%, respectively the other end markets grew.

Margins

Molex reported a gross margin of 29.1%, down 74 basis points (bps) sequentially and 134 bps year over year. The sequential decline in the gross margin was on account of lower volumes that were partially offset by favorable currency movements and lower commodity costs. 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 $167.4 million were up 7.5% from the previous quarter’s $181.0 million, with the operating margin shrinking 166 bps sequentially and 139 bps year over year to 9.5%.

Net Income

Molex’s pro forma net income was $58.3 million or 6.8% of revenue compared to $72.0 million or 7.4% of revenue in the Dec 2012 quarter and $67.4 million or 8.1% of revenue in the Mar quarter of 2012. Our pro forma estimate for the last quarter excludes losses related to unauthorized operations in Japan on a tax-adjusted basis.

Including the special item, Molex reported a GAAP net income of $44.8 million ($0.25 per share) compared to an income of $70.4 million ($0.39 per share) in the previous quarter and income of $64.9 million ($0.36 per share) in the year-ago quarter.

Balance Sheet

Inventories were down 3.9%, with inventory turns increasing from 4.8X to 4.4X. DSOs were flat at around 70 days.

Molex ended with a cash and short term investments balance of $712.9 million, down $3.9 million during the quarter. Cash generated from operations was $87.2 million, down from $167.4 million in the first quarter. Capital expenses were $55.9 million, or 6.6% of revenue, down from 8.1% of revenue in the previous quarter.

Guidance

Molex expects revenue of $870-910 million in the next quarter, up 2-7% sequentially. The pro forma EPS (excluding 8 cents 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 fourth quarter of fiscal 2013 was 41 cents, above 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.

In the near term, we expect the shares to remain under pressure due to weakness across key end markets. Molex shares carry a Zacks Rank #4 (Sell).

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