Plexus Corp (PLXS) 2006 Q1 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to the Plexus Corp. conference call regarding its fiscal first quarter earnings announcement. At this time, all participants are on a listen-only mode. After a brief discussion by Management, we will open the conference for questions. The conference call is scheduled to last approximately one hour. I would now like to turn the call over to Mr. Gordon Bitter, Plexus' Chief Financial Officer. Gordon?

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, and forward-looking statements are not guarantees as 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 earnings per share, excluding restructuring and impairment costs. Although the fiscal first quarter of 2006 does not include any restructuring or impairment costs, the comparable prior-year period did include such costs. All comments concerning earnings comparisons on this call will refer to non-GAAP, that is pro forma earnings. For a full reconciliation of pro forma earnings to GAAP results, please refer to our press release and periodic SEC filings.

Joining me this morning are Dean Foate, President and CEO of Plexus, and Paul Ehlers, Senior VP and President of Plexus Electronic Assembly, the Company's manufacturing operations. Today's call will begin with Dean making some brief comments about the quarter. I will follow up with details on the first quarter financials, and then we'll open the call up for questions.

Let me now turn the call over to Dean.

Thank you, Gordon, and good morning, everyone.

Last night we reported results for our first fiscal quarter. Revenues were $328.3 million with GAAP EPS of $0.28, which included approximately $0.02 of stock-based compensation expense versus $0.01 anticipated in our guidance. Revenues for the quarter exceeded our guidance range as a consequence of generally better than anticipated end market performance led by our medical and wireline networking. The higher revenues coupled with LEAN Sigma productivity improvements led to better operating leverage, driving our EPS performance well above our guidance range. Gordon will provide a few more details in a minute.

Let me continue by turning to a summary of our performance and outlook by end market sector. We had experienced our wireline/networking sector to perform well and it did not disappoint. Sector revenues were actually slightly better than anticipated due to higher demand later in the quarter as well as the the beginning of ramps in several new programs won in previous quarters. Looking to the second quarter, we currently expect lower overall revenues in this sector as a number of existing customers are forecasting weaker demand. This weakness will be offset in part by the continuing ramps of recent new customer program wins.

Our Wireless Infrastructure sector was down, but less than expected, as a couple of customers experienced improved demand during the quarter. Although the overall end dynamic remains lumpy with much of our business in this sector. As I outlined last quarter, our key end market customer of one of our significant accounts in this sector has exercised their option to manufacture some of our customer's product. We began to experience the impact of that decision this quarter. This event prompts a cautious outlook for this sector as we work to shift our concentration to customers with perhaps more stable end market demand. To that end, and on a positive note, we are currently expecting stronger performance in the second quarter, as we benefit from a new program ramp that represents a shared increase with a key account.

Although our Medical sector was down in the quarter, the outcome was better than anticipated as a result of seasonal strength and the faster ramp of new programs. As we highlighted over the past couple of quarters, we are working to overcome the sharp decline of revenues from the Medical account in the UK, where that customer experienced a regulatory challenge. Although the customer has recently announced that it prevailed in the outcome of the investigation, the future revenue impact to us is not yet clear. Additionally, over the past few quarters we have selectively pruned some underperforming relationships resulting in lower near-term revenues, but improved economic performance.

Looking to the 2nd quarter for the Medical sector, we currently anticipate a decline of revenues in the single digit percentage range as seasonal revenues reset and we work through the impact of the transition away from certain relationships. Looking out a bit further, we expect growth to resume in our third quarter as we continue to ramp new customer wins, as well as continue our track record of gaining share with key accounts. To further support our Medical sector strategy, during the quarter we obtained FDA qualification for Class 3 medical devices through PMA submission at our Chicago facility and ISO-1345 certification at our new facility in Penang, Malaysia. We anticipate Class 3 qualification in Penang in our fiscal 3rd quarter. Our Industrial/Commercial sector performed modestly better than expected as a few customers improved end market demand during the quarter. We anticipate a double-digit percentage uptick in the 2nd quarter on the back of share gain program ramps in combination with stronger end market demand forecasts.

Our Defense, Security, and Aerospace sector was up this quarter as expected, reflecting five consecutive quarters of modest growth. Looking to the 3rd quarter, we expect strong performance as we begin to ramp a significant new customer program in this increasingly important sector. In support of our Defense sector strategy, we obtained compliance in our [Rau] design center during the quarter.

Addressing our overall revenue concentration, revenue from our top 10 customers remained steady at 61% of total revenues this quarter. Juniper Networks represented 22% of the total, while GE advanced to 15% this quarter. Let me anticipate your question on Juniper. As you might recall, I stated last quarter that we did not lose share with Juniper when our concentration with this customer fell to 18%. Likewise, we did not gain significant share this quarter. Rather, the increase in concentration percentage reflects normal variation and the timing of orders for certain product lines and their direct order fulfillment model at quarter end. I would further point out our fiscal quarter ended does not always align with the customers. A strategy with Juniper is to manage the concentration in the vicinity of 20%, some variation quarter to quarter is to be expected.

Turning now to new business wins. Our sector-based business development engine performed well again this quarter, following two quarters of exceptional results. During the 1st quarter we won 16 significant new manufacturing programs, which in total will add 135 to $140 million in annualized incremental revenue as these programs begin to ramp during fiscal 2006 and on into 2007. Six of the programs are with new customers, while the remaining ten were share gains of existing accounts.

On the Engineering Services front, we've won more than $9 million in new product development business during the quarter, creating a healthy backlog through Q2 and stretching on into Q3. While we won new engineering opportunities in all key sectors, about 50% of the business was in our Medical sector with encouraging momentum in Industrial/Commercial, Defense Security and Aerospace sectors. Our technology business unit is returning to growth following a couple of quarters of strong financial performance.

Overall, I am satisfied with our regional performance. In the first quarter, we grew in all but one of our regional segments by focusing on sectors, customers, and opportunities that fit the unique value propositions of our various regional sites around the world. We experienced a revenue set-back at our Juarez, Mexico site as a result of a medical customer's request to transfer a certain business to a Plexus U.S. site. We are encouraged by the performance of our leadership team at our Juarez operation and we must now drive additional business into the site. Our growth in Asia continues at a robust rate.

Our newer facility in Penang, Malaysia is performing well against plan, and we continue to add S & T lines to support the growth. Additionally, we are encouraged by the growth in our facility in Xiamen. China. Full utilization of our investments in Asia is within sight, prompting us to consider further investment in technology and capacity as we move through fiscal 2006. During the third quarter, we will install our standard ERP platform in both facilities in Penang facilities to facilitate more efficient financial and materials management. We expect to install the platform in Xiamen during the fiscal fourth quarter. Importantly, the installation of the new ERP system will enable us to offer our agile direct order fulfillment capabilities to key customers in that increasingly important region of the world.

Addressing global capacity utilization, as we began fiscal 2006, we reassessed our assumptions for production capacity at each of our manufacturing locations. As a consequence of Lean Sigma-led productivity improvements, we have increased our maximum revenue capacity estimates at six of our twelve manufacturing facilities. As a result of these adjustments and the increases in tool capacity in Penang, our latest estimate of ASTool global capacity utilization is approximately 67%. down from the estimate we provided last quarter. Simply stated, our Lean Sigma initiatives are enabling higher revenues per square foot of manufacturing space.

Last, a few comments on our fiscal second quarter guidance. We are currently expecting revenue in the range of $330 million to $345 million with EPS in the range of $0.31 to $0.36. Some of you may have noticed the broader guidance range for revenue and EPS this quarter. The broader range reflects a conservative stance on the timing of the significant new customer program that requires an exceptionally steep new product introduction ramp. Steep program ramps and new technologies comes with many uncertainties, although our steadily improving financial metrics should provide some comfort that we're able to efficiently and productively manage our growth.

With that, I'll turn it over to Gordon. Gordon?

Thanks, Dean. And once again, good morning.

A great start to the new fiscal year. Revenues were at yet another record, this time at $328 million, and earnings, cash flow, and return on capital employed all continued to improve. I'd like to spend just a few minutes discussing the key reasons for the year-over-year improvement in EPS from the pro forma $0.09 in the first quarter of '05 to the current $0.28 per share, then I'll direct most of my comments on the sequential improvement from the fourth quarter of '05 and why earnings improved beyond initial expectations for the first quarter of '06.

Let's look against prior year. As you saw in the press release, revenues increased 14% over the comparable prior-year period, and the current year's EPS of $0.28 was much improved over the $0.09 pro forma of a year ago. Enhanced earnings over last year were due to a number of factors, the more important being: First, you may recall that our second site in Penang, [Seaside], began operations very late in fiscal 2004 and was still incurring in the first quarter of fiscal '05. The normal sort of losses associated with starting up such a large facility. This year, Penang Seaside operated very profitably in the current quarter, so there was a swing from a loss to a profit on a year-over-year basis.

Second, last year's first quarter included a $900,000 inventory writeoff in Mexico that thankfully did not recur this year. Third, incremental revenues of nearly $41 million certainly contributed to improved earnings, but in addition and more importantly, our sites operated much more efficiently in the current quarter as a result of the higher production levels and the realization of production efficiencies from Lean manufacturing and other productivity enhancements. Additionally, you are seeing the year-over-year improvement in the bottom lines of the operational leverage of the Plexus model.

I should add it was a modest benefit from a lower effective tax rate in the current quarter, 2% versus last year's 8%. Before turning to a discussion of the first quarter of '06 versus the fourth quarter of '05, let me talk about stock option expense. As you know, this is the first fiscal period in which we had to expense stock options in accordance with Statement of Financial Accounting Standards Number 123-R. Last year we accelerated the vesting of all outstanding stock options that were not in the money, and by so doing, we eliminated all but about 400,000 of overhang from prior stock option grants.

In our earlier guidance, we estimated that expensing stock options would cost us about $0.01 per share in the first quarter of fiscal '06. In fact, the actual Q1 expense came in at about $0.02 per share. This increase was mainly due to higher-than-anticipated grants to members of the Board of Directors, half of which vested immediately and to a higher stock price. Stock option expense in the first quarter of '06 was just over $800,000, of which $200,000 was included in cost of sales and $600,000 was included in SG&A expense. Stock option expense will not be an issue in the 2nd fiscal quarter of '06 as it is expected to be under $200,000. Stock option expense will return as an issue, however, in the third and fourth quarters, assuming that as expected, the Board of Directors continues to grant stock options or similar equity-based incentive compensation in the May timeframe.

Let me switch gears now and say a few words about the first quarter of '06 versus the fourth quarter of '05. Our prior guidance for the first quarter was to anticipate revenues in the range of $315 to $325 million and fully diluted earnings per share between $0.22 and $0.25, which included $0.01 per share estimate for stock option expense. Let's add back stock option expense then, and say that we were expecting to make operationally $0.23 to $0.26 in the first quarter. Instead, we reported $0.28 per share, which included $0.02 for stock option expense. I know this is getting confusing. So, without stock option expense, we earned $0.30 per share operationally. Accordingly, we are $0.04 to $0.07 ahead of our earlier guidance when you adjust for stock option expensing, which we think you should.

Revenues increased only about 2% sequentially, but we were able to maintain gross margins at 9.5% of revenues, despite an average 3.5% wage increase in the United States at the start of the fiscal year and the $200,000 of stock option expense recorded in cost of sales in the current quarter required by a new accounting standard. Many of our operating units, including Technology Group, which is our engineering business unit, performed exceptionally well in the first quarter. As Dean has already mentioned, many of our sites continue to realize operating and purchasing efficiencies derived from Lean manufacturing and other activities to enhance productivity, driving better-than-expected gross margins.

Let me turn to SG&A expense. SG&A expense declined by $1.3 million from the earlier quarter. This was the result of lower spending for Sarbanes-Oxley compliance and lower audit fees while absorbing $600,000 of additional expense for stock-based compensation not required to be expensed in '05 and accruing an additional $600,000 for bad debt expense. So, on an apples-to-apples basis, that is adjusted for the change to accounting for stock option expensing, the reduction in SG&A expense for the first quarter was nearly $2 million. SG&A expense as a percentage of revenues, declined from the fourth quarter 6.1% to 5.6% of our revenues. With gross margins at 9.5% of revenues and SG&A expense falling to 5.6% of revenues, the first quarter's operating margin was 3.9%, 50 basis points better than the 3.4% operating margin of last quarter. Except for a slightly favorable tax rate in the 1st quarter, 1.8% versus 4.3% in the prior quarter, there was not much net movement below the operating income line.

Let me turn to the balance sheet. The cash conversion cycle improved by just one day from the prior year end. Accounts receivable increased by one day. Inventories remain the same, but accounts payable were extended by two days. Cash flow from operations was $19.5 million. We also generated about $4 million from financing, principally the proceeds from the exercise of stock options, which in turn allowed us to finance $11.6 million of capital expenditures and still improve our cash position by almost $11 million. Parenthetically, we previously estimated the capital expenditures for fiscal 2006 would be in the range of $30 to $35 million. That earlier guidance remained unchanged below the rapid rate of expansion in Asia will most likely move us to the high end of that range.

As you know, we've been focusing on improving our after-tax return on capital employed, or as we sometimes refer to it, ROIC, return on invested capital, and in the first quarter, we achieved an annualized ROIC of 19.4%. We achieved no-pad margins of 3.8% and a capital employed turnover of 5.1 times. I should mention that we define capital employed as simply the balance sheet values of debt plus equity less cash, and that the capital employed turnover component of the ROIC statistic is based on the 2-point average of the opening and ending capital employed balances for the first quarter, which was then annualized.

No-pad margins were pretty close to pre-tax margins because of the very low 1.8% effective tax rate in the current quarter. The low rate, as discussed before, arises from two factors: First, the Company has tax holidays in Asia that extend through 2014; and second, in the United States we have NOLs, Net Operating Losses, to shelter income until such NOLs are either used or expire. These NOLs, coupled with previously-established valuation allowance on our U.S.-deferred tax assets, allow income earned in the United States to fall to the bottom line without tax effect.

Under U.S. GAAP accounting rules, we need to review the Company's current and projected U.S. taxable income at the end of each quarter to see if it is appropriate to reverse to income the remaining valuation allowance. Although this would create a one-time pickup on the tax provision line, the effective tax rate for the Company from that point forward would increase to reflect the application of U.S. statutory tax rates on domestic income. We currently are forecasting the tax rate to remain below 2% for the rest of the fiscal year, but as I just mentioned, this could change.

Let me now turn the call back to Dean.

All right, thank you, Gordon. Just a brief statement before we take questions. I will close by saying that overall, I am pleased with our performance this quarter. We continue to make good progress on the fundamentals and the opportunities for continued growth are right in front of us. Operator, this concludes my comments. We will now open up the call for questions.

[OPERATOR INSTRUCTIONS]. Thank you. Our first question is coming from Brian White of Kaufman Brothers.

Hi, good morning, guys.

Hi, Brian!

Can you talk a little bit about the defense opportunity? Is this a new customer? It will begin ramping in the third quarter or is this the second quarter and how big do you expect it to be?

Well, it is a new customer. It's a new opportunity for us that we have worked hard to win, and we have been building essentially prototype-level quantities or early production quantities here in Q1 and we will continue that in Q2. Paul is sitting here and knows a little bit more about the rampup, but at this point, we can not disclose the customer from a size standpoint, I would say that at full run rate, this could potentially rise quite quickly to a top kind of 15 list and eventually into the top 10 list as we move through the fiscal year. So Paul can talk a little bit more about the shape, which I kind of alluded to in the guidance.

So, as Dean said, we've built some prototypes last quarter, we're continuing that actually in the month of January. We're going to begin significant production here in the next couple of weeks and ramping fairly significantly here at the back end of the quarter, so, again, the shape is at the back end of the quarter where the ramp is.

Okay. And just how big do you think it could be over the next-- run rate-- over the next 12 months?

Well, I would say you would have to look at it when it's fully ramped. It could be top 10, approaching a top 5 customer run rate. That's as much clarity as I'd want to give out at this point.

Okay, and maybe just, where will you be manufacturing this, in the U.S., I assume?

Yes.

One plant or more than one plant?

At one plant at this point.

Okay, thank you.

You're welcome.

Thank you. Our next question is coming from Todd Coupland of CIBC World Markets.

Yeah, good morning. I was wondering if you could comment on the issues you're suffering in Mexico, and if I could just make one additional perspective comment. It seems like each one of the EMS companies that we've heard from so far this year had issues down in Mexico. I'm wondering, is that coincidental or is there a geographic/regional issue there that perhaps we're not aware of? Thanks a lot.

Well, it's really hard for me to reflect on our challenges relative to the others. I would just say that our challenges, as you're aware, first quarter last year we had a significant reduction of inventory that-- a significant amount of which which walked out the door and we also had some control issues that prompted us to take some significant action down there. We did have a few employees that were involved in the theft of materials, and some of those employees ended up incarcerated.

So we made some significant changes down there, not only in terms of processes, controls, and security, but we also took a good reset and look at the performance of the organization over time and made some changes to the management team as we moved through the year. I would say, and Paul may want to reflect on this as well, is that the performance of that organization from a customer satisfaction standpoint, from an execution standpoint, quality, et cetera, has improved substantially here quarter by quarter as we've moved through this year.

It's just that we have not driven a lot of new business into that location through the year because we were focused on stabilizing and improving the execution on the existing accounts that we have there. The comment I made about revenues being down currently at the site is really consequence of a particular customer that we have in Medical that had thought it would be a benefit to manufacture certain sub assemblies of their product in multiple locations and on further reflection and further more detailed analysis, concluded it was best to consolidate the manufacturing of that product into a single facility, and so we moved some of those assemblies up to our U.S. facilities.

Paul, you want to reflect on this as well or add anything to it?

Yeah, I think the other significant change we made down there along with some of the management team and some of the structures, we completed really the buildout of our focus factory structure and implementation of that. Dean and I were both down there a couple weeks ago and we feel very confident that we're ready to move forward with good, solid execution.

So, I guess to conclude, I think I'd look at the Mexico facility at this point as really a significant opportunity. The site is executing very well. It shows very well. We've got capacity there, and I think it represents a real opportunity for us here to grow certain customers in North America.

Okay. That's great. Thanks a lot.

You're welcome.

Thank you. Our next question is coming from Tom Dinges of JPMorgan.

Hi, good morning, guys. Real quick one on the utilization and kind of expansion plans going forward. As you'd mentioned, you're running about 67%, which normally-- and correct me if I'm wrong-- as you push closer to 80, you probably feel like you're a little bit too full, right, because you can't capture customer upside, so Gordon, as you look at the CapEx plan and reach kind of the high end there, what is that going to add as you guys go forward in terms of potential revenue capacity that you can capture? Or do you think that maybe another quarter or two and then you guys are going to really have to start thinking about possibly adding even more brick and mortar out there? And then I have a quick follow-up.

Yeah, Tom, Paul might want to amplify this, but we are currently looking at expansion opportunities both in Malaysia as well as China, and I think we'll be reaching a decision on those pretty quickly, probably in the next month or two. I think the real spending, if we do decide in those locations, most of that capital spending would actually be incurred in fiscal '07.

Okay. And then quickly, Gordon, just to kind of run through the quarter-to-quarter changes, some that are going to stay, some that won't on the SG&A side. You had roughly $2 million on an apples-to-apples basis that you reduced it. What would be kind of the expectation going forward from here, because you're going to get a little bit lower option expense, as you said, from the March quarter to the-- December to March. Should we continue to see that tick down? And then as you guys are seeing the revenue growth and the new opportunities, are you going to have to start adding a little bit more on the sales forces as we move through the year as you're saying it seems like a pretty good pipeline of opportunities out there?

On the SG&A, I would expect a modest future reduction in Q2, and then assuming the Board comes through with the stock option grant that they traditionally have done, you will probably see SG&A probably go up a little bit in Q3.

Yeah, I would comment on the size of the sales force. I think that, you know, as some of you have pointed out, we have perhaps an outsized SG&A expense that we've been carrying along here over the past couple years, and part of that was because of conscious decisions on IT and other areas, but on the other part, it was to build out our sales force and our sales strategy so that we could execute on top-line growth, and I really feel that you've seen the impact of the leverage on that organization today.

I don't anticipate that we have to add significant bodies to that organization or to continue to execute our models. Certainly there will be some fine-tuning and small, incremental additions, but we feel pretty good about that organization and the size of that organization and that its ability to continue to execute on top-line growth as we look forward here over the next couple of years.

Okay, thank you.

You're welcome.

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

Good morning.

Good morning.

You guys have seen some really nice operational improvement with your Lean Sigma initiatives, both last quarter and then this quarter that's led to pretty significant improvement in the operating margin. Are you going to continue to see leaps like that in terms of the Lean Sigma initiatives kicking in, or is this going to start to-- or when would it start to level out and become more of a continuous improvement initiative rather than these leaps that we're seeing?

Paul, you want to take that one?

Yes. You know, I think we've really got it defined as a continuous improvement initiative, and once in a while, when we go and implement it on a particular customer or in a particular location or on a new program potentially, we do see these leaps. We think that there will be continued improvement through the next couple of years. The more we progress on it, the more we find in terms of opportunities.

I would just add to that that a lot of this is drilling down in to where is gross margins going to go, and I want to be careful how I answer that, other than to say I've been consistent and steadfast in communicating that there's just nothing fundamentally restrictive in the marketplace in our ability to be competitive that prohibits us from seeing our gross margins rise above 10%, and I have consistently said that if we continue to improve execution, continue to improve productivity within our operating units where we can clearly see where we have productivity opportunities, that we will continue to make incremental progress.

Now, obviously, your ability to get there becomes asymptotic at some point and of course, the higher gross margins get, the more it becomes a target for customers, so things become self-regulating in terms of requests for cost reductions and reduced pricing to customers, but there's still room left for us to continue to improve, and the second benefit you get from the Lean Sigma initiative, or actually a couple of them, you get essentially improved working capital management, and you get very satisfied customers because it really permits you to deliver really high-quality product to them in a very agile way.

Okay. And then just a quick tax question, Gordon, on this valuation allowance that you're talking about. Can you give us a sense for when at the outside it would start to dissipate in the-- and the tax rate starts to go up and/or, if there is a reversal, what would be the mechanism to trigger that?

Let me answer the last part first. The mechanism to trigger would be a consistent history, if you will, or consistent quarterly profits in the United States from a tax perspective. Keep in mind that tax perspective includes any restructuring costs, so we have to look at it on a tax/tax basis. Essentially, you look back and then you're allowed to look forward for a like amount of time that you've generated profits and you can demonstrate the profits. What does all that mean? We've got about a $40 million valuation allowance on the deferred tax assets. I don't think it's going to happen in the second quarter. We have to look at it each quarter, as I said. Conceivably, it could happen in the third quarter. If I had to guess, I'd say it would be fourth quarter of this year, most likely in '07 issue.

Remember, when we took this valuation or established the valuation reserve, we took a big debit to the tax provision line. Well, we'd take a similar big credit to the tax provision line if the valuation allowance were reversed, and as I said in my comments, what that means is that going forward, we'd basically be tax-effecting the domestic increment to statutory rate. So the tax rate would go up. Those that believe that cash flow drives valuations shouldn't be concerned about this at all because we're still not cutting any checks to uncle Sam for tax purposes, so it has no effect on the Company's cash flows.

Thanks for the comment.

Thank you. Our next question is coming from Jim Suva of Citigroup.

Great, congratulations.

Jim.

When you mentioned about no restructuring charges, is it kind of' looking like we are out of that type of a thing going forward, we're kind of' restructuring-free?

Let me address that one, Jim. First of all, it's a general caveat we have to put out there because we have several prior actions and there are accrued liabilities on the balance sheet for these prior actions. Those accruals are based on certain assumptions that we've made, and insofar that something develops that changes those assumptions, we have to reflect revised accruals.

For instance, we're trying to sublease a facility in Seattle and we have to make several assumptions. If we're able to sub-lease that facility on better or worse terms than we built into the assumptions we established the original accruals, we'll have to adjust those accruals by taking a charge or credit during restructuring costs. So long-winded answer, that's why that general statement is out there because of the accrued liabilities for prior actions. That having been said, I'll pass it to Paul or to Dean as to future restructurings.

This is Paul, we look at it as we're pretty happy with our footprint. Certainly, you know, we've got as a percentage of footprint, a fairly significant footprint here in the United States, but we are also executing on a strategy to bring what we call "sticky business" into those locations by driving our Defense, Security and Aerospace business, by driving our Medical sectors, not to say there isn't other sectors and other business in those sectors that would support a U.S. footprint, but as you look out significantly over time, certainly business in certain sectors is going to be stickier to the yes.

So it depends on our success at executing our strategy and our ability to completely utilize the footprint that we have here in the United States, but at this point, you can tell from the numbers that we're doing a pretty good job here getting those locations to critical mass and delivering good results out of those locations.

Great, and then on the bad debt expense, I think you mentioned it was around $600,000. Is that a one-time thing or is there still a little more to come?

I'm afraid bad debt expense is never just a one-time thing. We have a pretty strict policy that when accounts age and get to a certain stage of aging or companies that we have been dealing with are clearly in financial distress, then we automatically establish an incremental bad debt allowance for those accounts, and that was required this quarter. That $600,000 is really $400,000 for one company that we had previously established a very large allowance for losses in the prior year and then another $200,000 for another company, who's kind of slowing down payment.

Okay, great, thank you and congratulations.

Thank you.

Thank you. Our next question is coming from Amit Daryanani of RBC Capital Markets.

Thanks a lot. Guys, just on the operating margins, obviously saw an tremendous improvement sequentially. Looks like SG&A percent was down since the lowest level in June, '01. Incrementally from this point on, what does it take you to get to the 10/5/5 operating model and do you see that happening by fiscal '06 now?

Gordon is rolling his eyes at this point, but as at one point in the past, he made a comment about 10% gross margins and hasn't lived it down yet, but I would say that a 10% gross margin is certainly within sight.

I would take a roll out of the account-- it's okay to forecast the number, just don't forecast a number and a date.

All right, so looking at the SG&A side, the 5% SG&A target then, assuming there's around $18.4 million, how much of that is fixed versus variable for you guys at this point? Can that number stay pretty flat with increasing revenues?

If you define variables as changing with revenues, very little of it is truly variable cost, but the accounting rules are becoming a lot more stringent and I talked to you about the incremental bad debt expense because of an automatic aging policy on our receivable. Stock options is another variable. I'm not sure what value our stock price is going to be trading at when the May stock grants come down because we've got a fairly volatile stock, the Black-Scholes valuation model on our stock is very very high. It's roughly 50% of whatever the stock is trading at at the date of the grant, so that injects volatility, so there can be volatility in the SG&A account, but it's not directly related to changes in revenue volumes.

All right. And then just looking at your new ones, for the last three quarters, the run rate's been at 140 million run rate, essentially, which is a really a big uptick versus the 75, 80 million rate in '04 and '05. Can you talk about what's driving that? Are you just being more aggressive on the sales effort or is there an increased desire to outsource by companies?

I'd like to think it's a result of us actually developing a strategy for going to market, aligning our folks into market sector teams and getting some great talent to lead those teams and getting people aligned in terms of performance and setting goals and holding people accountable to achieve those goals. And I just think that we have a much more disciplined approach; we have a much better targeting scheme, and we're focusing on the kinds of business that really fit our model, and it has led to significant improvement and much more predictable approach for us to go out and win business.

All right. And then just finally, what percent of your sales came from the Engineering Services this quarter? And also, if you could just talk about how the Engineering Services margins are relative to the corporate average out there, above or below that?

Sure, I outlined that when I was outlining wins, the wins that I gave you that were in this 135 to $140 million of run rate, that group of wins was all manufacturing, and then I outlined a second set of new business wins that were roughly $9 million that were new product development business within our Engineering Services company, so that gives you some sense. You could actually in terms of overall revenue, you could add roughly the $9 million to the $135 to $140 million to get to a total revenue opportunity. From a margin perspective, the Engineering Services business is-- we'll just say that the gross margins of that business are substantially higher than the manufacturing business and overall Engineering Services revenues as a percent of our total, I think, is somewhere in the neighborhood of 3.5% of Plexus' total annual revenues.

All right, thanks a lot, guys.

You're welcome.

Thank you. Our next question is coming from Kevin Kessel of Bear Stearns.

Good morning.

Good morning.

Just to be clear, when you talk about-- I think Dean you were mentioning the large, new program that's affecting the guidance range a little bit, is that new program the one you were alluding to earlier that's in the Defense Aerospace sector?

Yes.

And in terms of the overall target for the year, growth 15 to 18%, at this point how much of that growth would already be booked based on wins to date?

Well, I think from a confident standpoint, I would say that the bottom end of that range is-- we're pretty darn confident on, based on currently-booked business in one business.

Okay. And then in terms of the tax rate, Gordon, I know that like you just mentioned it might be reversing itself potentially going into FY '07. Where do you expect a normalized tax rate to be once the U.S. operations are again taxed?

Low to mid-20s. We've suggested we could develop a long-term model that you normalize our tax rate 20% to 25%.

Okay. In terms of the cash, you guys have done a phenomenal job on the balance sheet. I think your cash is up four times from where it was three quarters ago. What are the expectations for that cash and what are your expectations for cash flow from operations this year?

I can't give you a precise number of cash flow from operations. I can tell you we expect to maintain or have at fiscal year end cash balances at approximately where they are now. So we will have cash flow from operations that will finance $30 to $35 million of CapEx.

Okay. But in terms of acquisitions right now, you guys--

No, we continue to focus on organic growth. It's less risky and cheaper.

Got it. Thank you very much.

You're welcome.

Thank you. Our next question is coming from Carter Shoop of Deutsche bank.

Great, thanks. So just to clarify on the tax rate, it sounds like we're going to be less than 2% for the March and June quarter and then starting as early as the September quarter we'll see that tax rate go back to 20% to 25%?

No, I didn't say that. I said that--

Okay.

-- my best assumption right now is the 1.8%. You can always know our full fiscal year assumption by whatever our year-to-date tax rate is that we report. 1.8% is where I see it now. I tried to say that stuff happens, and if we become more profitable faster than we currently expect, then that tax rate could jump, but keep in mind, before it jumps, you're going to have a big credit.

Yes. I imagine that would be signalled out as a one-time credit?

Yeah, just like a one-time debit at the end of year '04.

I'm not saying it's going to jump in Q3, I'm saying it could, though? As early as Q3?

That is correct.

Just wanted to clarify that. And we're going to talk a little bit about you walking away from some of the Medical customers. How substantial were those and were they losing money or was that just a low-margin business for you?

Well, they were reasonably substantial in that they were material to the revenue line of our Medical sector, but the issue was that we were not-- we did not have a relationship such that we felt that we could continue to develop a significant a share with that business as we had hoped, so, the customers that I'm referring to had a fairly sizable chunk with Tier 3 competitors. We had a very-- in proportion to the total that are relatively small part of the business, and we just didn't feel it was in our best interests to continue to focus on it if we were not going to be able to grow and gain share.

Okay. And can we talk a bit about the new business wins you guys are ramping and what kind of operating margin you guys are realizing, assuming a similar type of cash cycle that you currently have on the balance sheet?

I'll let Gordon talk about the incremental, I guess a marginal improvement in--

It's hard to talk about the margins both in the new business because typically, there's a learning curve involved, so margins might start out low and as we gain experience building the product, margins get better. I would say we continue to expect, as we said earlier, some enhancement in the gross margins going forward in this fiscal year.

One of the benefits that I mentioned, that we talked a lot on the sector strategy also, is it's much better fits for customers that buy into our strategy, and so that means customers that really align with and where our expectations are on margin, right?

That is correct.

Okay, that makes sense. When we look at the second half of the year, we're going to see a pretty rapid reacceleration in year-over-year growth, and I believe that's mostly coming from new program wins? But at the same time, we're looking for some pretty good margin expansion? What's going to be offsetting the lower margin profile from the new wins coming on-line and starting off at below full run rates in the second half of this year?

Well, I think just if you look at the potential for accelerated growth, I think that we're going to continue to expand, you know, incrementally, margin in our existing facilities with the programs that we have already won, so there's this, there's this constant expansion of the existing programs. You need to look at it and say we've won a fair amount of new business here over the last couple of years, and even as we've moved through later '05, we saw some back end improvement in '05 and we're still integrating and improving the performance of those pieces of business, so.

I think this-- this sort of excuse that's been used in the industry that new business wins are going to crush your margins for a period of time is, at least I think we've worked beyond that. I think we've got a much more disciplined integration process; we're better at forecasting the impact of those early revenues; and so, I don't think that you should necessarily expect significant, a significant move backwards from gross margins based on new business wins.

Okay. That's helpful. I mean, you do get quite a bit in the industry. Two more quick ones here. For working capital outlook, do you think that we can keep the cash cycle where it is or do you think we'll see it expand a little bit in the second half of the year?

Well, you know, Gordon would typically answer this, but I'll answer it for him. I would expect that we're going to continue to make incremental improvement in the cash cycle.

And Gordon, I'm sure you're comfortable with that?

Yes, I am.

All right. And CapEx, sounds like that will pick up a little bit as a new facility comes on-line, or just to clarify, is that a new facility you're talking about in the China for the second half of the year that you're deciding on now or is that just capacity additions like adding SMT wins?

Well, no, we'll basically be out of capacity in the existing footprints in both China and Malaysia. I should mention, you know, it's not necessarily been decided to expand yet again in Malaysia. That's part of-- again in Malaysia. I should have framed it within Asia somewhere.

So we'd see a decent pop in CapEx in '07 as a result of that? Is that a fair assumption, assuming you go through with the plan?

Well, depends. I don't think you're going to see a huge increase in overall capital spending. We've probably cut back in some of the areas, so if we're going to spend $35 million this year, it might go to $40 million, but not off the scale.

Lastly, the bad debt reserves that have been, you guys have been incurring here, do you expect any of those to reverse in the second half of the year or what's the likelihood that we could see a positive tail wind here from some of these bad debt reversals? Well, from some of these bad debt reversals?

Well, if those guys pay me, I'll happily reverse it.

All right, but you don't think that's a likely scenario?

It's pointless for me to speculate. I just don't know.

Okay. Great, guys. Thanks again and congratulations on a good quarter and Gordon, good luck with that 10% gross margin.

Thanks, one of these days.

Thank you. Our next question is coming from Richard Kugele of Needham & Co.

Thank you, and again, good quarter.

Thank you.

Just to delve a little bit deeper into the Defense side for my own understanding. When you look at ramping of Defense relative to some other verticals, does it tend to be more complicated? I understand your comment that overall ramping of new business you've been able to mitigate much of that, but from a sector-specific standpoint, is it more complicated to ramp Defense? And then after the product is produced, do you go and just directly fulfill it or does it go through other contract manufacturers or is there another step before it finally goes to the end division of the government?

Do you want to take this one?

Yeah. So none of the programs we're doing today are what you would call primes to the government. So in every case, there's some other organization that delivers the product directly to the government, if that's the question.

Yes.

Yes, and the other part of your question, come a complexity standpoint,-- Every program has its complexities. Some are more challenging, some are less, but on average, the Defense programs are no more, no less complicated than in any other sector, really.

Okay, and then I guess just lastly, you had commented that you didn't gain or really lose any share at Juniper, but it is somewhat outside of your and their comfortable band of 20% or so. Should we assume that it's more likely going forward that new business wins drive overall revenue growth so that the percentage can decline, or do you think there would be some type of a mix shift that would move it down more towards-- on their part-- move it down towards something 20% or less?

I think collectively, and obviously, Juniper's a large customer of ours, so we talk to them frequently about their strategy, their fulfillment strategy. There's a lot of speculation on what Juniper is going to do in terms of EMS providers going forward, and of course, we're engaged directly in those discussions with the leadership team at Juniper. I think collectively, we are comfortable, both of us, with being in the 20% area, and we both recognize that there could be some aberration quarter to quarter based on the timing of orders, et cetera. I think from our standpoint, the only limitation on really gaining more share with Juniper at this point is that kind of 20% range number.

So as we can continue to grow and expand our business, I would anticipate if we continue to execute for Juniper, which we've had outstanding execution, great quality product, continue moving forward with great cost reductions for their product, we think we-- in fact, we know based on statements from them, that we have certainly been a contributor to their success in the marketplace because of the direct order fulfillment model we've been able to design and develop and deliver for them. So as we grow our top line, I would expect that we'll continue to gain additional programs and expand our business with Juniper, but it doesn't come in 1 million, 2 million little pieces; there are certain product lines that they need to decide where they want to have them manufactured and they need to have them manufactured and filled in the right geographies of the world.

So you have to look at it a product line by product line basis and realize there isn't much fine-tuning on the $30 million revenue level like you might expect.

That's helpful. Thank you very much.

You're welcome.

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

Hey, just a quick question. I guess on the margins again. Is there any structural reason you can't get back to the margins that you've had peak in the past, close to 90% on the operating line? Is there something different in the industry today in terms of pricing or competition that would prevent that?

Well, I'd like to think we can get to the 14% gross margins again, but I think that would be stretching it beyond reality. I think reality is such that there is-- that structurally, numbers in the 10 to 12% range are probably theoretically possible, but at some point they become self limiting, as I said before, because obviously, the customers pay attention to the performance of your company overall, and you start to stretch the numbers too high and you're going to get some self-regulation by customers saying it's time for the price reductions.

So the pricing environment would make it very difficult without a substantial, I would say reengineering of the concentration of our business in various sectors to try to get to a number that exceeds 12%. So I would say look at that band of 10 to 12% as a model attainable today with our model and the types of business we go after and the marketplace that we anticipate in.

Okay, thanks.

You're welcome.

Thank you. [OPERATOR INSTRUCTIONS]. Our next question is coming from [Pat McMullen of Armadillo Capital].

It's been asked and answered, thanks.

Thank you Pat.

Thank you. [OPERATOR INSTRUCTIONS] We have no questions at this time.

All right. Well, we've depleted the list. Well, with that, then, I'd just like to thank everyone for participating and their interest in Plexus. We had some great questions today. I'd just like to close by saying that we feel pretty good. Business is healthy. I'm pleased with the incremental progress that we're making on fundamentals, and I can certainly get visibility into improving the fundamentals even further, and I'm also very pleased that we have a predictable and business development engine that is really performing for us. So with that, I'll close. Thank you very much.

Thank you. This does conclude today's teleconference. You may disconnect your lines and have a wonderful day.

Thank you, Operator.