Plexus Corp (PLXS) 2004 Q3 法說會逐字稿

Good morning, ladies and gentlemen. And welcome to the Plexus Corporation conference call regarding it's third quarter earnings announcement.

(Operator Instructions.)

I would now like to turn the call over to Mr. Kristian Talvitie, Plexus' Director Of Investor Relations. Kristian.

Hello, and thank you for joining us today.

Before we begin, I would like to establish that statements made during this conference call that are not historical in nature are forward-looking statements. Forward-looking statements are not guarantees since there are inherent difficulties in predicting future results and actual results could differ materially from those expressed or implied in the forward-looking statements.

For a list of major factors that could cause actual results to differ materially from those projected, please refer to the company's periodic SEC filings. The company provides non-GAAP supplemental information, more specifically, net income and EPS excluding restructuring costs and the partial write-offs of goodwill. Please refer to the press release for reconciliations of the GAAP income and EPS to the non-GAAP supplemental data.

I will now turn the call over to Dean Foate, President and CEO, for some brief prepared comments, and then we'll open up the call for questions.

Good morning, everyone. Yesterday we announced sales for the quarter of $275 million. This exceeded the top end of our previously announced revenue guidance of $255 million to $265 million, and marks our fifth consecutive quarter of revenue growth. Our pro forma EPS result for the quarter was 8 cents. Gordon will get into more details on the financials but I would like to highlight a list of a few highlights.

Gross margins improved for the fifth straight quarter to 8.4% this quarter. SG&A, while up in real dollar terms, as expected remained at 6.5% of sales. Annualized inventory turns improved to 5.5 as we reduced inventories by over $30 million in the quarter. Our customer concentration remains among the most diversified in the industry. Our top 10 customers accounted for 54% of our revenue for the quarter, and our top 20 customers made up 72% of total revenue.

Juniper Networks was again our largest customer this quarter, representing 14% of our total sales. We had some very significant new engineering and manufacturing customer and program wins during the quarter. On the engineering front, we won over 20 new projects with customers such as St. Jude Medical, Radiant Medical, Respironics, Texas Instruments, and Itron.

On the manufacturing front, we won seven major programs. The list includes new programs at Juniper Networks, including programs from their new security products group. Also in our networking sector, we won a significant program with a new customer that we cannot yet disclose.

In our medical sector, we added new programs with current customers including Siemens and Draeger, and we also won a new program with a new customer, Gerber, and we continue to win industrial sector programs with customers such as AMX and GE. We expect to begin initial production for all of these new programs in our fiscal fourth quarter, with significant revenue impact coming in the December quarter.

I'm particularly pleased with the improving execution of our business development teams, the people in sales, marketing and operations that are working together to deliver more value and gain share with current customers, balanced with new customer growth.

Looking out to the final quarter of our fiscal year, we are currently expecting flattish revenues of $270 million to $280 million. We expect margin expansion overall in spite of higher compensation costs and anticipated start-up costs associated with our new facility in Penang, Malaysia. Consequently, we are currently expecting EPS for the September quarter in the range of 9 cents to 11 cents.

Looking at performance and outlook by sector. Our network and data comm sector was up 22% over the prior quarter, stronger than expected, as we continue to expand our revenue streams with a host of current customers as well as the success of a couple of our emerging technology customers.

Looking to the fourth quarter, we are currently expecting flat to slightly down results due to some near-term forecast weakness with a couple of customers and a program expected to go end-of-life with Plexus. However, looking into the December quarter, we expect the expansion of the sector to resume as we ramp new Juniper programs and other unnamed networking programs.

Medical is up 3% sequentially as expected. We expect strong single-digit growth of this sector into the September quarter as we continue to ramp programs with a few previously announced new customers including Kodak and GMP Companies. We are also looking for relatively strong performance of this sector in the seasonally strong December quarter.

Industrial/commercial was up 8% in the third quarter. As we look to the fourth quarter, we are expecting single-digit expansion of this sector. Computing was down 55% in the third quarter as expected. We are currently expecting this sector to decline again in the fourth quarter, with some modest improvement in our December quarter.

Our other sector was up 52% for the quarter, and was strong as expected, driven mostly by growth in defense and avionics businesses. For the fourth quarter, we are projecting continuing growth in the low double digits.

On a regional basis, we continue to see growth in all geographies where we participate, including the U.S., which was a growth leader in dollar terms this quarter. On a percentage basis, Asia wins. We have experienced 9 consecutive quarters of sequential growth in Asia and expect those sites to meet our goal of 10% of overall company revenue for this fiscal year.

Our global, as-tooled manufacturing capacity utilization was approximately 73% this quarter, with the highest utilization rates in the U.K. and Asia. Next quarter, we expect capacity utilization to dip as we bring on our new facility in Penang, Malaysia and begin operations there.

With that I will turn it over to Gordon for a review of our financials. Gordon.

Thanks, Dean, and good morning everyone.

As expected, our gross margins continue to expand during the quarter. Compared to the last quarter, margins of third quarter benefited from improved operating efficiencies which were, however, partially offset by the lower absorption of manufacturing fixed overhead expense as we reduce production levels in order to lower inventories.

As Dean has already noted, our inventories were down nearly $31 million from the end of the second quarter. I stated at the last conference call that we were expecting about a $20 million reduction, so we were very successful in reducing inventories, but the P&L suffered a bit.

SG&A expense for the quarter excluding restructuring costs was $17.9 million. This represents a $1.5 million increase from the prior quarter, but keep in mind that the last quarter's SG&A line benefited from a one-time credit of $1.1 million to bad debt expense, arising from the recoveries of two previously written off or fully reserved accounts.

SG&A for the third quarter included expense for additional travel and the use of consultants to document and test the company's internal control practices, as will be required by Section 404 of the Sarbanes-Oxley act.

In addition, we continued to expand the company's sales and marketing efforts both geographically and to better support our end market, that is, our sector-based strategies.

Let me spend a little time providing some color on the third quarter restructuring charge. It's a little unusual. Most of the restructuring charge in the quarter, to be precise, $4.67 million of the $5.5 million, was to essentially top off an accrual made in the first quarter of last year with the expected cost to close two leased facilities in the Seattle, Washington area.

At that time, that is, last year, we believed that we would be able to sublease the facilities by the end of June 2004. Accordingly, our initial restructuring estimate for these closures reflected a partial recovery or offset from the anticipated sublease payments.

Unfortunately, the market for commercial real estate in that part of the country remained weaker than expected and our earlier assumption of reducing our overall lease obligations by finding a sublessee proved too optimistic. The charge in the current quarter reflects the assumption now that we will not be able to sublease the space for any of the remaining lease terms of the two buildings.

Obviously we will continue to try to find the sublease. I would point out too that there is no immediate cash impact in this $4.7 million charge, it simply accelerates the recognition of expense. The actual cash will fall out with the next two to four years.

In addition, approximately $800,000 of the third quarter restructuring charge was to recognize severance and other termination expenses associated with the closure of a small satellite PCB design office in Hillsboro, Oregon, and its consolidation into our design center near Boulder, Colorado. As you may recall, last year the company decided to focus on PCB design only as an integral part of a broader engineering and design offering, and to not focus on the standalone or merchant PCB design business.

This consolidation unfolds what had been a standalone West Coast PCB design center into a broader, more capable design and engineering center.

Finally on the income statement, the tax rate remained at 20% for both the year-to-date and third quarter, and obviously that's our best assessment of the tax rate going forward for the year.

Turning to balance sheet, or, I guess, returning to the balance sheet, day sales outstanding or DSO and receivables improved to 46 days from the prior quarter end level of 49. A couple of large accounts resumed taking prompt payment discounts. Inventories as we've already discussed declined by nearly $31 million to $167 million, and inventory turnovers improved on the reduction in absolute levels of inventory as well as the higher-level of sales and cost of sales in the third quarter.

As noted during the last conference call, second quarter inventories were simply too high, as a result of a number of factors including new program transition and increased buffer stock put in place in advance of ERP system conversions at two large manufacturing sites.

Although inventories are sharply reduced, there is an even bigger $35.9 million offsetting reduction in accounts payable and, as a result, we did not achieve positive cash flow from operations despite the substantial inventory reduction.

Capital spending for the quarter was lower than expected. We only spent $3 million on capex in the third quarter, substantially below the third quarter's depreciation of $6.4 million.

The acquisition of the new Malaysian facility was expected to be financed in the third quarter, but transfer of legal title and, consequently, payment for the new facility has taken more time than expected. Title transfer and payment are now expected in August.

I should mention, however, that we have full physical access to the new site, and we are making good progress in making the necessary building improvements and installing the initial complement of production equipment. We still anticipate that the new Malaysian facility will be operational late in September.

We now expect that capex for the fourth quarter will be about 10 to $12 million, bringing the full-year total to approximately $20 million to $22 million. That's about $4 million to $5 million less than our previous expectation.

There's not much to report on financing changes during the quarter. Cash in short-term investments decreased by about $4 million and debt levels remained essentially flat. Debt is comprised of capital lease obligations of about $24 million and outstandings under the bank revolver of about $16million.

It's also worth noting that we recently amended our bank revolving credit facility to increase the size of that facility from $100 million to $150million, and to extend the term for an additional year to October 31, 2007. We were extremely pleased at the level of interest that the banks expressed in amending this facility, which was led by Harris Bank of Chicago. Thanks, Mike.

With that, I'll turn the call back to Dean.

Thank you, Gordon.

Fiscal 2004 is shaping up to be a solid rebound year for Plexus. Given the downturn of the market and the business in 2002 and 2003, we spent considerable effort to go out and win new business. Our rallying cry for the year has been "Back to a Billion," and we will deliver that level of sales in spades.

Our revenues have grown faster than any company in our industry organically. This growth has come without acquisitions. This organic growth clearly highlights the appetite of the market for our customer focus, value-added service offering, and the effectiveness of our investment in sales and marketing processes and people. As we look to the September quarter and into 2005, there's a short list of objectives that we must accomplish to take advantage of the leverage inherent in our business model.

First, we must continue to grow the top line to gain market share and scale, but with an increasingly targeted and planned full approach. We must validate the value proposition of a short list of sites that are currently performing well below the corporate average.

Delivering additional business into these sites alone will drive growth margins into the double-digit territory. Further opportunity for margin expansion comes as we continue to improve our overall capacity utilization and improve efficiencies through our lean initiatives.

Second, and very importantly, we must continue to expand the delivery of value into customer relationships through our engineering services organization, where the leverage is significant both in dollars and in customer strategy.

Third, we must intensely focus on improving working capital utilization and returns on capital employed. We are off to a solid start with a significant reduction in inventories in the June quarter. Further improvement will come from lean initiatives that drive higher manufacturing velocity and through supplier and partner managed inventory models.

Fourth, we must achieve our growth goals while reducing SG&A expense as a percentage of sales. The build out of our sales and marketing organization is nearly complete, and our planned ERP rollout at our high priority locations ends with the goal live in UK in February.

This positions us to moderate growth in SG&A looking forward, recognizing that we still face challenges with healthcare and Sarbanes-Oxley-driven costs.

Overall, I am gratified with our recovery to date. I am enthusiastic about our forward momentum, and I'm confident that we can make substantial progress at each of the objectives outlined to enable us to deliver our commitment to enhanced long-term shareholder value.

I want to thank you for your support, and, with that, we'll open up the call to questions.

Thank you, sir.

(Operator Instructions.)

Our first question is from Patrick Parr of UBS.

Good morning, guys.

Good morning, Patrick.

Couple of questions real quick. You have worked your inventory down this quarter, you know, as you are hinting, I guess, some better growth like in the December quarter. What would I expect the inventory trend to be in September and also in December, and also, I guess, the cash flow implications of that? Would it be positive cash flow in September or negative or what?

Yeah, let me take a shot, Pat. Gordon here. Pat, initially we were looking to further reduce our inventories by another $15 million. That having been said, as a result of the new wins that Dean announced, and we'll be taking on some of the initial inventories for those programs, so I'm now expecting inventories to stay relatively flat. $165 million to $170 million.

Because of the reduced cash flow, we would look for neutral to slightly positive cash flow from operations.

OK. Second quick question, the computing segment has obviously been diminished to very small level, yet you say that you do have some new wins there. Is that a segment that you remain committed to or is it becoming less important to your overall mix?

Pat, let me just clarify something first. We didn't talk about new wins in the computing sector. We talked about new wins in our networking, data comm, medical and industrial sector. So we haven't increased our market share in that sector.

I look at computing as a sector that has opportunities in it for Plexus. We certainly are providing value to customers that we have today in that sector. It's just a question of priorities for us, and as we build out our sales and marketing organization more around sector-focused teams, computing, because of our weaker position there, hasn't been at the top of our priority list in terms of building out those teams.

But, you know, I remain committed to the sector, and I think that there is opportunity for us. It's just going to come out a little further again as we begin to build our teams.

OK. Great. Thanks.

Thank you.

Thank you. Our next question is coming from Alex Blanton of Ingalls and Snyder.

Hi, good morning. I missed part of the call. Did you mention what your fourth quarter gross margin target is?

We did not mention specific fourth quarter gross margin. We've given just guidance on revenue and earnings per share.

Oh, ok. But you had mentioned that target before, I think earlier in the year.

We usually don't get into that.

You hoped to exit the year at a certain gross margin.

That was an ad hoc comment instantly regretted.

OK.

But seriously, we do expect further expansion of gross margin in the fourth quarter, but that will be partially offset by some expansion and SG&A costs.

Won't you benefit now if you stop reducing inventory? Then your production rates will go up, and you will absorb more burden, therefore, won't your gross margin benefit from that?

Yes, you're absolutely right.

So is there something that's offsetting that then?

No, I said gross margins are expected to expand.

OK. From that alone, even though sales would be flat?

That's correct.

OK. Now, what is your long-term goal on SG&A as a percent of sales? Because it's rather high compared with anyone else, and it's depressing your operating margin.

You are right. Let me probably take this. This is Dean.

I mean, obviously, we've talked about my longer term gross margin targets to be in that 10% to 12% range, and operating income to be in the 5% to 7% range, so that implies the target on SG&A that clearly says that we've got to flatten out or moderate the growth, and we've got to start to bring it down to, you know, 7% and 6% and on in order to get to that operating...

So what you're saying is you're targeting 5% operating margin and you're going to get that by raising the gross margin, not reducing SG&A.

No, we have to do both, Alex, really. That's one of the points that Dean mentioned, but going after incremental sales is not just pursuit of market share, per se, but to get us that scale that we need to bring down the SG&A. There's a lot of fixed costs obviously in our SG&A.

OK.

Let me just get into this a little bit. You have to understand where we came from here. Going back a couple of years, we really had very little scale or people resources committed to sales and marketing. And we spent some time here, in particular over the course of the last 18 months, building out that team, so that had pushed up our SG&A cost to support sales and marketing, you know, essentially ahead of revenues.

Now we're seeing a tremendous growth in revenues here during the course of the year, so we're seeing a lot of success based on that investment. But we don't need to scale the sales and marketing organization at the same rate we're going to grow revenues. I mean, obviously we'll be able to moderate now that the growth in SG&A related to sales and marketing people as we go forward.

Additionally, it's important to remember that we've been going through a major IT project, putting in ERP systems in multiple sites over the last couple years. We've talked about doing one more location in the coming year, 2005, in the UK, and that then allows us to scale back on the IT costs associated with going forward with people as well.

OK. Good. Thank you.

One more thing, it's apparent that the current trend and thinking in the tech industry is that the better the earnings this quarter, the more I want to sell the stock. Because it can't possibly continue, and there's got to be a peak, right? And you could see it yesterday in spades. It was amazing. So what do you think of that proposition? That tech is at a peak now, and is going to go down from here, what do you think of that?

Well, I think that -- well, first of all, I think that people are overly pessimistic, but I would also say that we're a service organization to the tech OEMs, and even if the tech OEMs see some moderation of growth going forward does not mean that an EMS provider cannot grow.

Well, I don't think people are talking about a moderation of growth. Some people are talking about a decline in business. A moderation of growth from, say, Motorola's 40% increase to a 20% increase, I could see that, but what's so bad about that? I mean, what do you think of this whole mindset here?

Well, you know, all I can say is, you know, we have forecasts from our customers here that go out to 2005 and they are forecasting growth. Now whether their overall product lines, and some of these bigger companies', you know, other product lines are struggling that we don't participate in, you know, we're not seeing that sort of thing at all reflected in our forecast going forward.

OK. Thank you.

You're welcome.

Thank you. Our next question is coming from Brian White of Kaufman Brothers.

Hi. Good morning, guys.

Good morning.

You know, when we take a look at, you know, some of the issues you've had as far as your growth initiatives from the rapid top-line growth that you've seen over the past few quarters, when do you think we can start to get some of this behind the company, sort of a breakout quarter? Is that going to be maybe in the December quarter, the March quarter, or when can we start to get some of this behind Plexus?

Well, I think, Brian, I really outlined really what our limitations are to having a breakout quarter when I talked about my objectives, so, I mean, we still have some sites performing below corporate average because they don't have enough revenue scale to stand the chance to make decent numbers.

Now, we went out and built a sales and marketing team, brought in business in somewhat, you know, I'll call it a chaotic fashion, but I want to be cautious on that because it doesn't mean that we didn't win business and price it properly and know that we can make money at it, but we were not mature enough in our attack to the marketplace yet to be able to specifically target pieces of business that fit each and every location.

And, in fact, in some locations, we essentially oversold and had to digest a tremendous amount of business for multiple customers at the same time, which caused us some indigestion at some of those locations.

So for us, we need to go out and we need to be more targeted and more intelligent about our growth and make sure we can pull it into these locations that are below the corporate average. Like I said, validate their value propositions, so ensure that the business is sticky in those locations, or reconsider the value of those locations to customers.

And when you talk about double-digit, you know, gross margin percentages, at what timeframe can we look for that?

Well, again, Brian, I'm saying we look out into 2005 and are quite optimistic about our ability to generate returns. Now, I don't have pieces of business in my back pocket here that we can drop into those locations, so I can't -- I'm not going to get pinned down here on a specific quarter in terms of when we're going to have success at each and every one of those locations.

OK. Does it make sense to keep those open still?

Well, that's -- you know, for us, we believe it does. We had some very tough discussions here over the course of the year about what our footprint needs to look like. But I would also -- as I outlined, we grew, you know, the United States here has been, in dollar terms, the biggest growth engine for the quarter, so there still is a need for capacity, you know.

The issue is we haven't been as targeted as we need to be with these locations. So my feeling is we need to get ourselves focused on finding the right pieces of business for those locations. I believe that they're out there. If I'm proven wrong, then we'll make other decisions.

Just finally for Gordon, on the inventories, great job on inventories declined $31 million sequentially. What percentage of that was finished goods and work in process versus raw material?

Yeah, the raw materials went from roughly $128 million down about $107 million. Work in process went from about $52 million down to $46 million. And finished goods went from $19 million to $13 million.

OK. Great. Thank you.

Mm-hmm.

Thank you. Our next question is coming from Steven Savas of Goldman Sachs.

Thanks. Good morning.

Good morning.

I was waiting for somebody to ask you when we're going to have world peace?

It's out a couple of quarters, Steve.

Yeah.

So I guess I was wondering if you can get us a little more color on some of those new wins. I think you alluded to, particularly on the networking side, some significant growth in December. You said there's a customer you can't name where you had some sizable wins.

Can you give us a sense either, you know, of a couple of those individual wins or an aggregate, kind of what size are we talking, and then if we were to roll it out over -- you know, how many quarters do you think it's going to take to kind of have that new business ramp? Is it a very quick ramp? Sometimes there are very long ramps over four quarters, something like that.

If you could just give us some more color, that would be helpful.

Sure.

I talked about seven new, major new manufacturing wins. There were actually a few smaller ones that I didn't talk about, but the aggregate is probably in the range of $85 million to $100 million with those wins.

The ramps for all of them are going to begin really in the later part of our September quarter here and more significantly in the December quarter. Some of them are going to ramp a little quicker than others because they are actually transferred programs in from other locations, but as I look at the forecast, we're going to see it take a couple, three quarters before they're all fully ramped.

Now, I would caution that you can't just go ahead and lob $100 million on top of the business and not anticipate that there's not, you know, erosion of the other business. I mean, it's normal in our industry to see 5% to 7% decline based on end-of-life of programs and that sort of thing in business, so you've got to be careful about how you model it, not to take what you think are running out now and lob on $100 million.

OK, and then you guys have won, you know, pretty good chunks of business over the previous couple of quarters. Are those largely -- you know, by the end of September quarter, are some of those earlier wins largely rolled out and ramped up, or is there still some other stuff that's going to linger into December? Again not new ones that you just won in this quarter, but from previous quarters?

Yes, we're getting to the point here that by probably into the December quarter where most, if not all, of those programs that we've been talking about over the last couple of quarters are reaching their full ramps.

OK and then just a quick question for Gordon. Tax rate for next fiscal year? I think last time you'd been talking kind of mid-20s, roughly. I know it's very hard to estimate at this point based on geographic mix, but is that still, you know, hold somewhere in the mid-20s?

Yes. Internally, till we get this thing tied down, we're using 25% for our preliminary assumption, so I can't give you a better number than that.

Great. Thank you very much.

Well thank you.

Thank you. Our next question is coming from Michael Walker of Credit Suisse First Boston.

Thanks a lot. Good morning, guys.

Good morning, Michael.

Just a question back again on the gross margin. In March, you had a lower gross margin because of, you know, the manufacturing problems associated with too many programs coming on line at the same time, and then in June, you had a margin situation because of the inventory.

So I guess my question is, in September, are all those things cleared up such that you're running on a normal inventory situation and you don't have a lot of programs coming on line all at once, and does that enable gross margin to get, you know, up quite a bit, and I guess why doesn't it get kind of back towards the 9% range?

Well, as I said earlier, in response to Alex's question, we do expect gross margin expansion in the September quarter, and the effect of that expansion on the bottom line will be moderate somewhat by higher SG&A expenses, but yes, we do expect gross margins to expand. And for the factors that you mentioned, yes, we also will be ramping some new programs, but we don't anticipate difficulties will be encountered in the second quarter, which somewhat badly impacted our gross margins.

Then as I mentioned earlier, also we're looking for relatively flat inventory levels Q3 to Q4, so we won't have the depressive effect of lower production, which certainly hurt us in Q3.

OK. So I guess my question here is then the issues in the March quarter, are those completely cleared up by now?

Substantially, yes.

OK. And my second question is on the networking business. You said earlier you expect some weaker demand due to weaker forecast from a few of your customers. That's kind of the first I've actually heard of that from the networking perspective. I wonder if you'd give us some more color there.

That's why I said, we have a few customers that have taken their forecasts down a little bit. We also have had, you know, a piece of business here that we talked about vacating Plexus now for probably, I don't know, somewhere like three or four quarters and it just continues to hang on, and I think it's finally going to disappear here in the fourth quarter, which will take it down a little bit.

But right now it's not expected to be down dramatically. It's just going to be flat to down a little bit.

Can you quantify at all the size of that end of life program?

Yes. I just want to mention, it was a startup company as well, but it's not a large piece of business.

OK, thanks. And then my last question is on the subleases, which you're not finding, you know, sublessees for right now. If you do find them, how do you account for that? Do you kind of see a one-time gain or would you expect that sort of through the P&L?

You'd have to credit the restructuring costs, so it would be a credit coming on the restructuring costs, I believe, Michael.

OK. Thanks a lot.

Thank you. Our next question is coming from Chris Whitmore of Deutsche Bank.

Good morning, guys.

Good morning, Chris.

A couple questions.

I wanted to come around and come back to the gross margin question one more time. Gordon, in the past you talked about 20% contribution margins, gross profit contribution margins, as you ramp new program wins, and over the past couple of quarters we've seen that the contribution margin range at about half that rate.

And given that, you know, you've been taking market share, you've been winning a lot of new business, etc., is the issue here pricing? Did you price this business pretty aggressively to bring it into your facilities and that's why we're seeing the margin pressure?

No, Chris, I wouldn't characterize it as pricing. As Dean said, we've been aggressively going after business but in a fairly disciplined way. You know, stuff happens. When I said 18% to 20% contribution margin that sort of is in an idealized world, Chris.

As you know, in the second quarter, we incurred higher than expected transition costs as we ramped up three very large programs. You may recall three programs went from virtually zero to positions in the top 10 or 12 accounts. And you know, frankly, it was a burden on us and we were strained and taxed to do it. And it probably cost us $1 million to $1.2 million. This quarter, of course, we've got lower absorption of fixed costs because we thought it very necessary to bring down inventory.

So yeah, my 18% to 20% contribution margin remains, you know, what it should be in an idealized world, but stuff happens. But it's not ineffective pricing.

So what should we think about for contribution margins as we ramp this new batch of business here in the December and March quarters?

Well, I think it's -- we don't anticipate any extraordinary problems transitioning this new business, so, you know, I think we can accommodate these ramps without having the problems that we encountered in Q2, Chris.

OK, and what kind of impact should we expect from the Malaysian plant ramp on margins going forward? Is that going to be a significant drag as you bring that online?

Yes. Well, yes. It's going to cost us probably half a million bucks in Q4 in the September quarter, and I would expect that to moderate in fiscal '05. But I'd be surprised if it didn't have at least this modest depressive effect early in '05.

OK. And then, lastly, one more networking question here. Do you think the cuts in orders that you've been seeing is the result of softening end market demand or some customer actions to reduce their own inventory levels?

Well, I know with one of them in particular, that's kind of in that top to top-five list within that customer set, I know they had backed off a little bit because they had overdriven the inventory situations just a little bit at their end customers, so there was a bit of a pause here that we are going to see in this quarter and we expect it to begin to recover in the following quarter.

Thanks a lot, guys.

You are welcome.

Thank you. Our next question is coming from John McManus of Needham & Company.

Yes, good morning.

Good morning, John.

Could you give us some idea of what the SG&A level, dollar level, might be in the fiscal fourth quarter and is that then a kind of a level for fiscal '05, or do we see escalation every quarter in fiscal '05?

See, John, I just know I get too precise, but certainly, you know - we're looking for gross margins expansion. I would expect -- and that's going to be partly eroded by SG&A. It's going to be up a little bit for a number of reasons. We're bringing on some new production, we've got some depreciation on IT equipment, we've got continued marketing support expansion.

So I would expect, you know, SG&A probably will be up, I'm going to guess $500,000 to $600,000.

And could you just give us some perspective, how many ramps do you have in the fiscal fourth quarter and fiscal first quarter compared to the -- I guess maybe 15 or so that you might have had in the fiscal second quarter?

Yes. John, we just announced the seven major program wins, so as I said earlier, we're starting to get to the tail end of those, you know, 14, 15 of them. You know, our efficiencies are starting to improve on those, and we expect those to be largely completed as we start getting into the December quarter.

The newer ramps, there is going to be, as I said, seven major program wins. All of them begin towards the back end of our September quarter and the real action with those starts to take place in the December quarter.

But I would also say that -- I talked about some of the names associated with those programs. Although there are a couple of new ones in the mix, and we're going to have some work with those, a number of them are with existing customers. And typically with existing customers, we're able to be more efficient in the program ramps because the relationship and expectations in those things are well understood, and we're much, you know, it's much easier for us to plan a more normalized transition and ramp up of those pieces of business.

So I'm optimistic that we're going to be more efficient in those ramps in the coming quarters.

And lastly, could you give us some general feel for capex there in 2005?

John, we're still working on our financial plan for 2005, but, you know, if you want to swag, $25 million.

Thank you.

Thank you, John.

Thank you. Our next question is coming from David Pescherine of Smith Barney.

Thank you. Gentlemen were there any inventory sales in the quarter?

Nothing significant, no.

How about, you know, can you give us a sense of what the engineering revenues are as a percentage of the overall business and maybe where the margins are and just generally how that business is doing?

Sure. Engineering typically has been running 4.5%, 5% of overall revenues. I haven't stated specifically what their margins are, but their gross margins are accretive to overall gross margins, so they are running at a premium to overall.

And just a little more color on engineering, we've seen quite an improvement here in the pipeline. We talked about 20 new wins. I think we're doing a much better job identifying opportunities there. You know we're going to have to probably see 2004 growth in engineering sales, roughly, maybe 8% for the year, so it's fairly modest, but it is recovering nicely.

And then Dean, maybe you can just then give us a sense, you're not going to give us what the exact gross and operating margins are, but maybe how far away are we from getting back to what you consider to be kind of 100% level for margins in that business?

Well I'm hoping that we're going to see this over the course of the next couple of quarters. Based on what we're seeing now is a substantial improvement in the pipeline of opportunities, and if we're able to continue to close on them at the rate we did this quarter, we're going to start to see some pretty substantial improvements in margins in engineering.

And just on the new facility in Penang, can you give us a sense as to how many customers you may have committed to that facility already?

Boy, we've got at least -- we have got a handful. You know, names I can think of off the top of my head, there's four, and they're decent names. Some of that, we're priming the pump, but the existing facility there is substantially, you know, busting at the seams, so we're going to be relocating some business from the existing site over there so we can increase scale with other customers that will remain. Some of it is new.

Great. Thank you.

You're welcome.

Thank you. Our next question is coming from Jim Savage of Wells Fargo Securities.

Hi, gentlemen.

Hi, Jim.

When you had two, three quarters of really substantial growth starting last September, it did end up having an impact on your gross margins. Are you expecting, as you go into the December quarter, if you start to see that same sort of growth again, that you will be able to manage through the growth more effectively this time than last time, and if so, why?

Well, Jim, yes, I think we can manage through the growth more effectively because, as I said, we want to get more intelligent about the growth.

So, you know, we've been -- I'm going to talk more about this as we get into our year-end conference call, but we're realigning the way we do business development around market sectors and market sector teams, and setting specific objectives for those teams relative to growth in the sector, relative to the amount of share we expect to gain with specific customers, relative to the penetration of value-added services into those customers, and relative to where the business goes in terms of our facilities and locations globally.

So, we're moving to what I would consider to be a much more strategic and planful approach to the way we develop business. You know, there's no question we went out there and said -- we set the bar up high and said, look, we've got to -- you know, for market presence reasons, for, you know, the good of the organization, we needed to drive ourselves back over a billion dollars, and we did that in a very, you know -- we just rallied went out there and got business and said we're going to bring it in wherever the customers want to put it and we're going to get it in there as quickly as we can without having to price it below what we thought we needed to price it at to make good numbers.

But going forward, I think it's just a matter of being a little more planful and bringing it in, in a more choreographed way. And I think we can do that, and we're already starting to see the results of those efforts now.

So Dean, you think we're going to see that in the December quarter then?

I think we're going to see better execution in the September quarter as we bring in these customers. Like I said, these are customers -- many of them are customers we're doing business with today. And we're going to see improvement.

But we're not going to fill up. We still have -- like I said, we still have sites that are under-performing that need business, and we're not going to have those filled up in the December quarter, and that really is part of the -- for us is part what's going to really begin to break us out, is bringing those sites up closer to the corporate average.

Can you also remind us what the seasonal patterns that you would be expecting as you go into the end of the year and the beginning of calendar '05 would be?

Sure. We typically see a pretty strong quarter in December with medical. And I would anticipate that it will be similar again this year. March quarter, which is typically under pressure with many of our competitors that focus more on the consumer-type businesses, for us tends to be still an OK core. May not be quite as strong.

We would expect to see medical actually come down in the March quarter because of the strength of the December quarter, but usually medical still grows beyond what our fiscal fourth quarter was of the prior year. So, you know, that's really the seasonal pattern for us, and we continue to grow from there typically.

Do you think that you can offset some of the normal weakness of the March quarter with those new programs as they ramp?

I think we can because our business tends to be less -- you know, our networking, data comm, industrial sector business tends to be less cyclical with what you see with the consumer products-driven type business.

OK. And I guess beyond that, if we're looking -- obviously you're winning a number of new programs with the existing programs other than what looks like an inventory correction with some of your networking customers. Are you getting any changes or meaningful changes in forecasts on some of the long-running programs above or below where previous expectations had been?

Really the forecast has been, I would say, a little bit more stable than we had seen historically. So, you know, we see customers that are forecasting just, you know, good-paced growth rather than looking out into next year. Some companies are actually doing quite well on the growth rate, so there's some exciting growth going on with some of them.

OK. But none of that -- this is not the economic sensitivity; this is just actually the specific programs that you're involved with?

Correct.

OK. If we go back again to SG&A, I'm sorry to be beating a dead horse --

That's all right. We anticipated you guys would beat on that one too.

Obviously you're expecting there to be a little bit further SG&A expansion. At what point do we begin to see that flatten out in terms of -- in dollar terms so that we begin to get the leverage on higher revenues?

I think clearly in Fiscal '05, Jim, you know. As Dean mentioned earlier, for instance, we've been bringing on additional marketing and business development resources in ahead of the revenues, and that is pretty much complete now.

We're going through what we call our cost center reviews to review the SG&A accounts, this week, as a matter of fact, and the message we've sent out to all the cost center managers is that, you know, we've got to moderate the growth of SG&A. In fact, we're basically targeting no growth in SG&A beyond normal, you know, salary increases.

So any new programs really have to be justified. So I think we're getting pretty close to stabilizing the SG&A.

And you've also been expensing the ERP rollout?

Well, some parts of it get expensed, some parts get capitalized, according to some, you know, accounting rules. But the capitalization part is pretty much over now because we've clearly begun the amortization. We've been amortizing the previously deferred costs on the ERP rollout in 2004.

And the expense portion, you expect to be finished -- the large part of that finished in the second fiscal quarter?

That's correct.

OK. Thanks very much.

Good.

Just to get off my soapbox, the Sarbanes-Oxley has put a pretty substantial cost burden on us. It's an initial burden as we go through all the 404 compliance issues. It will be a continuing cost burden once it's stabilized and everything is in place.

Thank you. Our next question is coming from Thomas Dinges of JP Morgan.

Hi, guys. Couple of quick ones for you.

Dean, you mentioned the push to get revenue back to a billion and really increasing the SG&A and the sales efforts that you guys have there. Are any of these contracts -- you mentioned all of them, you know, you came in and brought them in at good margin, but are there any that you look at them now and you have to go back and say, you know, we probably priced this business a little bit lower than we should have considering engineering efforts that we needed to put into them, or is there anything in that aspect there that's also, you know -- might keep the margin down a little bit as you ramp some of these, or as they come into ramping now over the next couple of quarters as you talked about?

Well again, we didn't go out and, you know, price any of this stuff at a point that we didn't feel that we couldn't meet our target overall margins. We walked away from a number of pieces of business because we just couldn't make the numbers work. So we're not out there lost, believing this stuff. We really - we believe in winning it on the value we can provide our customers.

Now, you know, some of the integration costs, some of those things when you transition business in a little bit more of a sellers' market, you can sometimes get paid for some of those kinds of activities. And of course we're certainly moving through what was more of a buyers' market through most of last year if not all of the year, and we just weren't able to recapture some of those initial start-up costs, which you can in a little bit more favorable marketplace.

Now whether we'll be able to begin to do that here looking forward with other pieces of businesses is uncertain. But, you know, pricing is -- a normal part of our business here with customers, is to go through and review pricing on a quarterly bases with our customers.

You know, many times these programs are quoted on what is really a margin basis or margin model business, and we expect to be able to make our margins as we see material pricing fluctuate, you know, and we usually have a profit improvement or margin improvement relationship or as we put engineering efforts in or profits efforts into improving yields, that sort of thing, that we split some of those margin improvements with the customer.

So, you know, if you could look into the individual locations that we have around the globe, our individual sites, you'd see that a great number of them are executing well within the overall gross margin targets that we're talking about here.

OK. And then, real quickly, you had a very -- another very strong quarter of engineering wins with another 20 new programs, and a lot of those with very solid customers, but my question is more so when we compare engineering wins with manufacturing wins, the crossover from those had always been where you'd have a couple of those cross over.

Has that changed at all in the dynamic where stuff is -- you're seeing a little bit less of a crossover from wins that you're seeing on the engineering side translate into manufacturing wins, or has anything changed there at all say over the last, you know, 6 to 12 months as you guys have focused a lot on bringing in more of the manufacturing dollars to get yourselves back up over the billion dollar mark on the revenue line?

There's no question that we saw a bit of a drought there in crossover business, because our focus really had been around filling up the manufacturing organization. More of the recent wins over the past few quarters, though, that story begins to change.

If you look at some of the business that we're working on in engineering today, programs that we've won over the past couple of quarters, the ones that we've just brought in, there's probably a good $110 million to $120 million worth of manufacturing revenue that should come out of those programs. Now, that's not nearly what it was at one point in time, but given the recent recovery of new programs into that organization, the penetration of our existing customer base with the engineering organization, I'm pleased at the progress that we're making.

OK. Thank you very much.

You're welcome.

Thank you. Our next question is coming from Reik Read of Robert W. Baird.

Hi. Good morning. Dean, you guys had talked about last quarter that you had hired 1000 people within the first six months and really having planned to do that in the entire year. Can you talk about, you know, where are those folks right now from a training perspective and learning curve perspective, and how might the improvement that you're seeing there help out from a margin perspective, and can you also talk about, you know, since then, how many new hires have you added?

Sure. Well, let me just give you a head count update. At the end of last quarter, I think we were right around 5900 heads, right now we're at 6100 worldwide, so we actually brought in a few more during the quarter based on the, you know, little more sizable revenue that we achieved during the quarter.

Most of the heads earlier in the year came into Asia and Mexico. We did have some hiring elsewhere in the U.S., but most of them were in those geographies, and again this quarter, you know, we had somewhere in the neighborhood of small growth in Asia, maybe 40, 45 heads in Asia, and somewhere in the neighborhood of 180 to 200 in the Mexico facility, actually under 200, that would be a pretty fair amount. So it's supporting growth there.

And can you talk a little bit about, you know, given that you've taken on so many more people more rapidly than you expected, you know, where are these folks from a training perspective and learning curve?

Well, they're definitely coming up the curve now. Most of them came on very quickly in the earlier part of the year, and most of them are direct labor, those folks that are fairly long here now on the training curve, and we're starting to see the impact of that and the performance in the locations where they are.

Is it fair to say that you've caught up and that you're at a little more of a-- or you are at a normalized level?

We're getting close.

OK.

A lot of people brought on in Malaysia, Penang specifically, and there's a lot of people who have previously worked in consumer electronics, so a lot of people who we're hiring have prior experience in electronic assembly, which is quite helpful.

Great. Thank you.

Thank you. Our next question is coming from Dave Miller of Tradition.

Good morning, guys.

Good morning.

Some of the new wins that you're bringing on including the most recent seven major ones you mentioned, are any of those programs going into some of the factories or the facilities that are struggling?

Yes. So we are going to see some improvement at certain locations.

OK. And then what type of business do you think is appropriate to bring into there? I know you mentioned that -- I guess computing may be less of a priority there, but I think maybe that it's a little bit more difficult to try and help out facilities here in the US. What type of end markets do you think would go into those facilities more likely than not?

Well, it depends on the specific facility. I don't want to get pinned down too tightly on specific locations, but, you know, there certainly is some improvement that we need in our medical business and more complex higher-level assembly falls fairly nicely into our sweet spot, so we should be able to make that happen. Networking in data comm works well. And, in particular, some of these industrial-type customer defense-related businesses could also be helpful in certain locations.

Part of it is really around the geographic presence that is considered of value to certain customers. And we're seeing that as we sell into more certain geographies that there is still some level of a preference to manufacture close to home with some of these companies because of the complexity of their products, and their relatively inexperience in outsourcing.

Right. And in the defense area, have you bulked up your sales team enough that you think you can bring in enough new business to keep it captive here in the U.S.?

Well, you know, we've actually had quite a bit of success in defense without really trying too hard, and now we begin to, over the last six months or so, we've been taking a good hard look at that business, understanding the regulatory issues associated with that business, the security clearance issues associated with that business, and we think that it matches up nicely with our -- you know, our regulatory understanding and infrastructure related to the medical and some of these other things.

So, we think that we can get some good defense business, some sticky defense business into some of our locations here in the United States, but we're going to want to concentrate it to one or two locations because of the regulatory issues.

OK. Great. Thank you.

Thank you.

Thank you. Our next is coming from Chris Lippincott of KeyBanc Capital Markets.

Good morning everyone.

Good morning.

Just wanted to see if we go back into the air for a second, in terms of capacity utilization, I think you had mentioned overall tool manufacturing utilization was 75%, but what was the utilization for engineering?

Well, engineering has improved a little bit, but again, we always talk about it, utilization is probably not the right way to look at it. We look at it more in terms of the billable percentage. And the target billable percentage of engineering is the engineers need to be billable 80% of the time to funded projects. That number is probably running in the mid 70's right now.

But I would remind you that, you know, essentially you could look at the engineers as sort of a fixed cost element, so, you know, it's almost a dollar for dollar drop here as they get more revenues and move their selves up to that 80% level.

You had a major -- what kind of time frame can we think that, at some point, we may start to see some of this optimal billable time? Because I know that typically engineering is sort of a good leverage point for you guys.

It is. You know, the momentum is clearly there with the new program wins. This isn't going to fix everything here, the 20 new wins or so that we had this quarter, but it certainly gives us an encouraging view looking forward that here over the next couple of quarters, we may see some decent recovery.

So you think sometime, maybe first half, you might start to see some benefit from that leverage?

Yes.

OK. And just in terms of sort of the -- going back to the site inefficiencies, can you tell us how many sites were inefficient? Perhaps, you know, how far they were below the corporate average?

I don't think we want to get into that level of detail. I'm sorry, Chris.

OK. Thanks.

You're welcome.

I think we'll take one more call here.

Thank you. Our final question will be coming from Todd Coupland of CIBC World Markets.

Yes, good morning, everyone.

Good morning.

Just to your return on capital and inventory turn's objectives, could you just remind us what those are?

Well, on the inventory, near-term, we want to get to at least the six times inventory turnover and return on capital employed -- there's probably 100 different definitions of return on capital employed. Internally, we use operating income over capital employed as the measure, and we've got a long way to go to get that return above our weighted average cost to capital. It's got to get up in the mid teens. But that's not going to happen overnight. It's going to take a few quarters.

And what capital number should we be using in that calculation?

Well, you can use debt plus equity minus cash, or you can go the hard way through the top of the balance sheet down.

OK. OK. And I guess I just want to go back -- I know you don't want to talk about the spread in utilization, or maybe you can if not mentioning what the different sites are, if you could give us an idea of what the spread on utilization is, firstly.

And then secondly, we've seen Solastik (ph) in Sanmina here basically call out that the markets have changed from a year ago, and they took restructuring and they've stepped up and taken additional restructuring, and it sounds like you guys are going to wait at least a couple of quarters to see how these programs ramp, and so you won't be making that additional rationalization decision until at least the beginning of the calendar '05 year.

Could you just talk about whether or not that logic is -- am I reading your logic correctly there?

Well, I think in some respects, you are. I wouldn't pin it down to an all-or-nothing decision related to every site that's under-performing, but, you know, we look back a year ago and, you know, we were coming out of a pretty tough patch where we were seeing declining revenues and we were shutting sites down and taking costs.

And we recognized that, you know, we can put our energies into continuing to shut down sites and try to take costs out to try to somehow get ourselves back to success, or we can draw a line in the sand and say, look, we've taken costs out, now we're going to grow the top line and we're going to grow our way out of this problem.

And I think that, you know, we made the right decision for the you know long-term benefit of the company and the shareholders and everyone -- all the stake holders, and I'm quite pleased about the progress we've made. It's been quite phenomenal. We have a substantial amount of momentum looking forward. But we also have to face reality and say, hey, we did not -- you know, as the tide rides here, we did not lift all boats equally.

And you know now with the better, I think more targeted sales approach, we are at a point here where we can give it the good old college try, so to speak, here, to make sure we can lift the other boats that haven't been pulled along with us, and if we determine that the value proposition isn't there.

If the business isn't sticky, if we're forcing business in sites that aren't going to there be for the long term, then we need to reevaluate the value of those locations to our ongoing customer base, and we're going to take the next six months or so here and utilize our improved processes, and try to target business, try to get it into those locations.

I'm quite optimistic that we have a very high probability of succeeding, and that's the direction we're on. But we're going to face reality here if we're not successful.

Great. Thanks a lot.

All right. Thank you.

All right, everyone. With that, that was the last question for the day. I would just like to thank everyone for participating this morning, and I want to wish you all a good day. Thank you.

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time, and have a great day.

Thank you.