Plexus Corp (PLXS) 2006 Q2 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to the Plexus Corp. conference call regarding its fiscal second quarter 2006 earnings announcement. At this time, all participants are in a listen-only mode. After a brief discussion by management, we will open the conference call for questions. The conference call is scheduled to last approximately 1 hour. I would now like to turn the call over to Mr. Gordon Bitter, Plexus' Chief Financial Officer. Gordon?

Thank you, Sandra. Hello, everyone, and thank you for joining us this morning. 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 also provides non-GAAP supplemental information. More specifically, net income and earnings per share, excluding restructuring and impairment costs. All comments concerning earnings comparisons on this call will refer to non-GAAP earnings. For a full reconciliation of non-GAAP earnings to GAAP earnings, please refer to our press release, and periodic SEC filings.

Joining me today are Dean Foate, President and CEO of Plexus, and Paul Ehlers, Senior Vice President 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 second quarter's financials, and then we'll open the call up for questions. Let me now turn the call over to Dean Foate. Dean?

Thank you, Gordon, and good morning, everyone. Last night we reported results for our second fiscal quarter. Revenues were $337.9 million, with GAAP earnings per share of $0.40. Revenues for the quarter were consistent with our guidance range, while EPS exceeded expectations. Our Lean Sigma operational initiatives improved competency in ramping new programs, and the strength in our engineering services business combined to drive the leverage in our model. We had a good quarter, and once again I am pleased to note that there were no restructuring charges or no impairment costs and therefore, no non-GAAP disclosures. Once I have completed my comments, Gordon will provide you with a more complete road map of our improvements relative to our first quarter and the comparable period last year.

Let me continue by turning to the summary of our second quarter revenues and outlook by end market sector. Our Wireline/Networking sector was down this quarter, although the decline was less than expected. We benefited from better than expected end market demand from existing customer programs, as well as a fast ramp of a newer customer program. Looking to the third quarter, a combination of favorable program share shifts to Plexus, program ramps and end market strength is currently expected to drive double-digit growth in this sector.

Our Wireless Infrastructure sector was up modestly this quarter. We had anticipated better performance. End market demand for a couple of customers in this sector failed to materialize to the level anticipated at the beginning of the quarter. The headwind looks to continue into our third quarter, as we are currently expecting this sector's revenues to contract in Q3.

Our Medical sector was down in the quarter, as expected. As outlined last quarter, the following are the drivers for the decline: First in Q2, we are coming off of a seasonally -- the seasonal strength that we typically experience from a leading customer in our first quarter. Second, the disengagement from underperforming customer relationships. And third, the continuing difficulties of a Medical account in the UK. Looking to the third quarter for the Medical sector, we currently anticipate a return to growth, as we benefit from a program that originated in our Engineering Services organization. This program is now ramping in one of our manufacturing facilities in Penang, Malaysia, where we recently achieved ISO 13485 certification, and expect FDA Class 3 qualification in the near future. This Medical program is a great example of how we've leveraged our new product development expertise to penetrate an important growth account for Plexus.

Our Industrial/Commercial sector delivered strong double-digit growth in the second quarter, as a number of customers experienced improved end market demand. Additionally, we continued to gain share with a leading account in this sector. Looking to Q3, we expect growth to continue. Our defense, security and aerospace sector was up this quarter as expected, reflecting 6 consecutive quarters of growth. Looking to the third quarter, we currently expect exceptionally strong performance as we ramp to full production programs for a confidential customer in this increasingly important sector. In addition to the defense sector regulatory compliance achievements announced last quarter, we are working to achieve ITAR compliance at our Neenah Design Center and [COMSET] compliance in one of our Wisconsin manufacturing facilities by the fall of this year.

You can anticipate that we will continue to invest in the capabilities required to service the defense, security and aerospace sector, as it is an important strategic initiative to deliver sticky customers into our U.S. footprint. Addressing our overall revenue concentration. Revenue from our top 10 customers represented 58% of our total revenues this quarter, down 3 percentage points from last quarter. Juniper Networks represented 20% of the total, while GE contracted to 11% this quarter, largely as a consequence of seasonality within GE Healthcare.

Turning now to new business wins. During the quarter we won 11 significant new manufacturing programs, which in total, will add approximately $50 million in annualized incremental revenue, as these programs begin to ramp during late fiscal 2006, and on into 2007. 2 of the programs were with new customers, while the remaining 9 were market share gain with existing accounts. While the dollar value of wins was admittedly lower than the exceptionally strong performances of the prior 3 quarters, I am not troubled by what can be a seasonally slow quarter for new business wins. Our funnel of opportunities has expanded again this quarter to a record 1.5 billion of qualified new business. Additionally, the targeting discipline within our sector teams has dramatically raised the quality level of opportunities, so that they more closely match our value proposition. Boosting confidence further, we classified about $500 million worth of these opportunities as near-term, higher probability. A high percentage of these opportunities are with existing customers, where the probability of success is dramatically higher, when compared to winning a new customer.

On the engineering front, we won more than $10 million in new product development business during the quarter. This strong performance creates a healthy backlog of engineering work through year end, stretching into fiscal 2007. While we won new opportunities in all of our key sectors, once again, our penetration in Medical sector was very strong, representing over [60%] of the new business wins. Our technology group business unit is back to growth, and is contributing nicely to our financial performance, and perhaps more importantly, to our value-added services strategy.

Addressing capacity utilization and global growth investments. As I outlined last quarter at the beginning of 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 estimates of maximum revenue capacity at 6 of our 12 manufacturing facilities. Our as-tooled global capacity utilization was approximately 68% at the end of Q2. Revenue growth in U.S. and Asia is expected to drive capacity utilization into the mid-70% range or higher, as we exit fiscal 2006. While we can add additional equipment and people to increase capacity in the U.S., capacity expansion at Asia will require additional investments in brick and mortar in Penang, Malaysia, and Xiamen, China.

Additionally, as mentioned last quarter, we are installing our standard ERP platform in our existing facilities in Penang and Xiamen to facilitate a more efficient financial and materials management, as well as enable our agile direct order fulfillment capabilities, an important value-added manufacturing capability for key customers served in that region of the world. The Penang ERP installation will be completed in Q3, while Xiamen is scheduled for completion in the following quarter, and maybe stretching on into the following.

Last, a few comments on our fiscal third quarter guidance, and the revenue outlook for the full year. For the third quarter, we are currently expecting revenue in a range of $390 million to $405 million, with EPS in the range of $0.50 to $0.55, including about $0.02 for stock-based compensation. With the exception of our wireless sector, we are currently expecting growth in all end market sectors. As outlined earlier, leading the growth will be in our wireline, and defense, security and aerospace sectors. Looking to the full year, the strength of new programs won over the last few quarters, coupled with improved visibility for end market demand, suggests that our revenue growth will approach 20% organic growth for the year, exceeding this year's target range of 15 to 18%, and last year's 18% growth rate. Now let me turn the call back to Gordon.

Thanks, Dean, and good morning, once again. This was a record quarter for both revenues and earnings. Although we've posted record revenues for the past 6 quarters, this is the first time that net income exceeded an earlier record, one that was set more than 5 years ago in the first fiscal quarter of 2001. The prior record net income was $13.2 million, so net income in the second quarter of '06, which was $18.5 million, easily eclipsed the prior record by a wide margin. In addition to record earnings, the second quarter of '06 also saw further improvements in cash flow and after tax return on capital deployed. As I have on prior earnings calls, I would like to first discuss the year-over-year improvements in non-GAAP earnings. Then address the sequential improvements from the first quarter, before concluding my comments with some observations on the quarter end balance sheet and cash flow.

Against the prior year's second quarter, as you saw in the press release, revenues increased about 11% over the comparable prior year period, to $337.9 million, and the current year's EPS of $0.40 was much improved over the $0.12 non-GAAP EPS of a year ago. Enhanced earnings over last year were due to a number of factors, but very broadly, higher earnings in the current period were attributable to higher revenues and the Company's operating leverage. That is, higher levels of production were achieved a relatively fixed expense base, with a consequential improvement in our financial metrics.

Let me turn to the specific factors accounting for the year-over-year improvement. First as I just mentioned, incremental revenues contributed significantly to higher earnings. Second, as you may recall, the Seattle manufacturing and engineering site was closed at the end of the second quarter of 2005. And most, but not all, of the programs in Seattle were transferred to other Plexus sites. We have essentially achieved the expected benefit of this prior year's restructuring action.

Third, you may recall that our second manufacturing facility in Penang, Malaysia, had just begun production at the beginning of fiscal '05, as was incurring the normal sort of start-up losses during Q2 of '05 that you would expect. The new facility in Penang is currently operating at a very respectable level of profitability. Fourth, we also spoke a year ago, or so, about a number of underutilized manufacturing sites in the United States, and the challenge that this presented for our business development team to secure suitable programs for these underutilized sites. While we have enjoyed a measure of success in adding new customers to these previously underutilized sites, and I can report that all of our U.S. manufacturing sites operated profitably in the second quarter of this year. In addition, our engineering business unit technology group is also operating at a much higher level and is substantially more profitable than it was a year ago.

And finally, 2 factors below the operating income line have provided a modest boost to the year-over-year improvement. Higher interest income earned on higher cash balances contributed about $0.02 per share of improvement, and a lower tax rate, we had a 0% tax rate this quarter versus 8% a year ago, contributed about $0.03. So about $0.05 altogether per share of the year-over-year improvement in earnings per share was from nonoperational improvements. But still, $0.23 of the $0.28 improvement did come from operations. Just a couple of points -- further points on the second quarter comparisons. First, stock option expense was only about $200,000 this quarter, most of which was included in SG&A expense. Accordingly, the new accounting rules for equity based compensation did not have very much of a distorting effect on the quarter-over-quarter comparisons. As indicated in the press release, however, this will be a bigger issue in the fiscal third quarter and in subsequent periods.

Second, the effective tax rate in the second quarter came down from 1.8% in the first quarter of fiscal 2006 to 0. This reduction was due to a favorable outcome of an income tax audit in the United Kingdom. I will provide some additional insight about our tax outlook in a few minutes.

But let me turn first to a discussion about the second quarter, compared to the first quarter of fiscal '06. Although revenues in the second quarter increased quite modestly from the first quarter's level, the increase was just under $10 million, or about 3%, approximately half of the revenue improvement actually fell to the operating income line, which expanded our operating margins in the second quarter to just about 5.3% of revenues. While some of the improvements stem simply from higher revenues, a greater percentage of the improvements arose from operational efficiencies that Dean alluded to in the earnings release. We continue to derive operational efficiencies through the application of Lean Sigma, and other techniques, to improve both labor productivity and the efficiency and agility with which we purchase and provide components to our focus factories. These improved operational efficiencies were of particular importance this quarter in the ramping of new programs.

Gross margins rose 150 basis points in the quarter to 11% of revenue. SG&A expense increased by about $2.1 million and represented 5.7% of revenues, a higher percentage of revenues in the prior quarters, 5.2%. But please keep in mind that the first quarter's SG&A had a credit of $1.2 million for the recovery of previously written off accounts receivable. The second quarter SG&A lacked that credit, and had higher accruals for variable incentive compensation than the first quarter. As noted earlier, operating margins for the second quarter were just about 5.3% of revenues, and this represented a 50-basis point improvement over the first quarter. Below the operating income line, if you look at our financial statements included with the press release, you will see that we have broken out interest income, and presented it separately on the face of the income statement, as has become a more important account with the higher level of funds we have to invest.

And finally, turning to the second quarter balance sheet and cash flows. Our push to improve the cash conversion cycle was temporarily stalled in the second quarter, as we built inventories to support the much higher revenue growth anticipated for the third quarter. We also added some buffer stock in Asia, as an insurance against any hiccups that may arise during the conversion in May to the Company's standard ERP platform at its 2 manufacturing sites in Malaysia. Although days in accounts payable increased quarter-over-quarter, it was not quite enough to compensate for the expansion of days in inventories, and the cash conversion cycle increased by a day. This is a temporary setback, and we are still anticipating improvement in inventory turnovers in the second half of the year.

Cash flow from operations was $26.2 million, which compared favorably to both the $3.9 million generated in last year's second quarter, as well as the $17.4 million generated in the first quarter of this year. We also generated $15.7 million from the exercise of stock options during the quarter. Capital expenditures were about $11.9 million for the quarter. As a result of the strong operational and financial cash inflows, cash and investments increased $30 million in the quarter, to just shy of $150 million. The rapid rate of expansion in Asia will most likely result in some acceleration of capital spending into 2006. I currently expect that capital investments for this year will be somewhat higher than previously anticipated, probably in the range of $40 million to $45 million.

Let me conclude with everybody's favorite discussion, our tax situation. You may recall that I said the second quarter's tax rate benefited from a favorable result of a tax audit in the United Kingdom. We currently expect that our effective tax rate for fiscal -- for the rest of the fiscal year will be 1.2%, rather than the previous estimate of 1.8%. Probably not enough of a difference to change your models or valuations. More interesting, however, is the outlook beyond the current fiscal year. As many of you know, our low effective tax rate is due to 2 factors. First, tax holidays in Asia, that extend for several more years. And secondly, net operating losses in the United States. Because we established a valuation allowance on the domestic deferred tax assets at year end of fiscal 2004, income earned in the United States flows to the bottom line without tax effect for financial reporting purposes.

You will recall that I mentioned a substantial inflow of cash from the recent exercise of stock options. The exercise of stock options typically results in additional losses for tax purposes, but not for financial reporting under GAAP, which pushes out the time when we may have to take back to income a portion of the valuation allowance. Thus tax deductions arising from recent stock option exercises should allow us to maintain a low effective tax rate for longer than we originally thought, probably into the middle of fiscal 2007. Let me turn the call back to Dean Foate. Dean?

You're right, Gordon, I always enjoy the tax discussion.

My favorite, too.

Let me conclude on a confident note. We had another very good quarter, marking the mid-point of our fiscal year. Barring an unforeseen significant negative event, the second half of our fiscal year should be strong as well, giving us the confidence to assert that we will exceed our targets for revenue growth and return on capital employed for the year. We are now turning our focus to our priorities and plans for fiscal 2007. As I look ahead, we have some competitive weapons at our disposal. First, the strength of our value-added services offering, working both ends of the product life cycle. As examples, on the manufacturing side, our value-add extends as customers increasingly rely on us to build completed products, and leveraging our direct order fulfillment capabilities. On the engineering side, our business has returned to growth, as customers are again looking to Plexus to develop innovative new products. Second, our global lean manufacturing and supply chain management model delivers exceptional execution in agility, quality, on time delivery, and total cost, including the all important working capital, resulting in the highest levels of customer satisfaction loyalty.

I sometimes here folks say that manufacturing is manufacturing. It isn't. Just ask our customers, who are increasingly referring to our model as world-class. Third, our sector-based business development strategy is gaining us market share with existing customers, while penetrating our value-added services. We continue to intelligently add new customers that fit the Plexus model. Our new business development pipeline has never been healthier, and the probability of success with these opportunities never better. Fourth, Plexus' people, including the many new people that have recently made the choice to join our team, are increasingly becoming a competitive advantage for Plexus. We are developing and tracking the talent needed to grow this business. Our nearly 7,600 people around the world continue to nurture a culture of execution and customer focus. And finally, the strength of the Plexus financial model, that is delivering industry leading metrics, creating flexibility and competitive advantage that we can leverage to sustain, or possibly accelerate, our growth. I hope you can appreciate why I am so optimistic about the future of Plexus. Operator, we will now take some questions.

[OPERATOR INSTRUCTIONS] Steven Fox, Merrill Lynch.

Gordon, just to start off on the taxes again. If you were going to model next fiscal year, I guess, the first half you're saying below 5%. What would the second half be, in terms of how it would jump up?

Steve, as we have said before, it is really hard to gauge. But if I had to build a financial model, I would put something in the low 20% range.

Okay. And then looking at the new military aerospace program that's ramping, Dean, can we provide any more color, in terms of what exactly type of program you're doing? What capabilities the customer found attractive where you're doing it? And when does the program peak -- sort of, get up to peak run rates?

Well, I think that's a good question for Paul to take. Because he is so close to it in the manufacturing organization. So let him start out, and I will add any additional color if I can think of anything original to say. Go ahead, Paul.

Sure. So first of all, we really can't talk anything about what the program is. In terms of the benefits the customer is looking for, they're really looking for a lot of the value-added services that Dean was talking about. So the engineering support we offer on the front end, our supply chain solutions, and just a general confidence that we are the right supplier to help them ramp a program very, very quickly, and very predictably.

Can you say whether it is a subassembly or a full assembly or anything along those lines?

Well, we would say that it is more than 1 assembly. There are a couple of product technologies here, and they are completed products when they go out of Plexus.

Okay. And then the last question would just be on the wireless side. You're saying it is all demand related at your customers, no lost business. Is that correct?

That's correct.

Okay. Thank you.

Jim Suva, Citigroup.

Thank you, and congratulations. Can you discuss a little bit about your operating profit margin outlook? Very impressive this quarter. You're basically 5.2 to 5.3%, where you kind of see that going above 6%, and what type of utilization are you kind of building into things?

Well, to take the second part of your question first, Jim, I think Dean's talked about the capacity utilization moving up. We have a pretty simple model. For all intents and purposes, we don't have any tax rate to worry about. And so if you work from the mid-point of the guidance we gave you for earnings per share, and put in a reasonable estimate for SG&A, you will see that we expect further expansion of our operating margins into the next quarter.

Yes, but I am talking kind of beyond that.

Well, I think beyond that becomes more of a strategic decision, as to how further do you want to expand margins, versus what kind of trade off you might want to do for higher levels of growth, that Dean alluded to. So I think we would cap out or moderate the operating margin, to drive it it's potential maximum.

Okay. And at what level would you view that as capping?

Well, I think right now, it is probably industry leading. I don't think it would get much beyond 6% in the longer term.

Great. Okay. Thank you. Congratulations.

Thomas Dinges, JPMorgan.

Gordon, maybe go into a little more detail about perhaps what kind of an expansion, in terms of square footage, that you're talking about in both Malaysia and China. It sounds like you've probably -- knock out some calls in those facilities to add some square footage there. And then I have a quick follow-up, as well.

Yes, Tom. In China, that's certainly the case. We have a fairly modest footprint in China now, just about 60,000 square feet. That building was designed to have a wall, as you said, knocked out, and we can expand from 60 to 120,000 square feet pretty quickly. We're in negotiations, as we speak, to do that. The facilities in Malaysia are not readily or efficiently expandable. And we're presently in the -- looking for a third manufacturing facility. It probably would be about the same size as the current 2 facilities, say roughly 200,000 square feet.

Okay. And then quickly just on the engineering business. Can you give us a sense of how much that was in the revenue base, and then also just an update on your guys efforts to utilize a little bit more global footprint for the engineering. How those efforts are going, that would be helpful.

Revenues for TG, technology group are about $10 million for this quarter. We continue to expand our Asian, our Penang-based design center. It has been an increasingly important center for us. And candidly, we expect it to continue improve its capabilities and its contribution.

Okay. Thank you.

Amit Daryanani, RBC Capital Markets.

Congratulations on the quarter, guys. Looking at your margins, their certainly the highest in the industry, north of 5%. Look like they will go about 6 next quarter. What's the expectation going forward, and the part I am really trying to get at is, if you remain north 6%, I would suspect your customers would potentially come back to you, and try to renegotiate contracts at lower prices, or [inaudible]. Do you fear that at all right now?

Let me comment on that. I think this is obviously something that we debate internally. But I would also remind folks that we have consistently been saying that margin performance above 10% is in the realm of possibility in the competitive environment that we are in. You look back, and we were at 1.14% gross margins. We said that those days were probably gone, due to pricing pressure in the marketplace. We said that maybe there was 200, maybe 300 basis points of pressure, in terms of pricing, that was going to come out of the gross margin line. But we have said that we could continue to get the gross margin number up. And which of course we did now. So I am not sure that we had a lot of believers historically, but that's the reality of it. So we're out there competing, head to head, with all the other names in the industry. The competition is certainly on price, as well as on the value-add and execution and a number of other things. But I can tell you that our customers aren't giving us a great premium in pricing, just because we're decent guys to work with. You have to be very, very competitive.

So I would suggest that right now, our better than average margin performance is really the result somewhat of our focus on what you refer to sometimes as nontraditional markets. Although they've been traditional for Plexus. The addition of 1 new nontraditional market, which is the [SEMs], the significantly improved performance of our engineering organization. And last I would just say that we are getting a productivity and execution premium out of our manufacturing organization. I just couldn't be prouder of these folks, both on the material side and the manufacturing side, for the execution premium that they have generated at Plexus. So I think the model can run here at 10, 11% of the gross margin line, and as Gordon suggested, can get up to about the 6% point on operating margins. But also, as I alluded to and as Gordon suggested, it may be wiser for us, rather than continue to drive margin, may be to look drive growth in the marketplace. Not getting away from who we are. We're not going to go off on a wild tangent here, and get into the consumer products industry or commodity products. But we think there is an opportunity, right now, to leverage our strength to accelerate potentially top line growth in the coming years. It is a point of debate for us in the next couple of quarters.

All right. Thanks. Just a question on Juniper, then. The recent news that Juniper added EMS provider in Asia. How do you see that playing out regarding your relationship with Juniper? Do you see some of the higher volume work going away from you, and that getting offset with some higher mix work?

Right now, there is essentially no predicted change or impact to Plexus' revenue with Juniper's current announcement. We are obviously, in very close discussions with them. We are trying to, as best we can, assist them in crafting the right strategy for their products. But I don't see us necessarily losing share. There may be some shifting around of who builds what, but I don't see us losing share. And quite frankly, I think any shifting around would potentially be beneficial to us.

And just finally, you raised your revenue expectation about 3.5% from your prior midpoint, that's about 45 million incrementally. Reasonable to say that's all being driven by the defense wins you've had? Or are you starting to see some end market tailwind there?

We're starting to see some -- as I said, we're going the see the growth rate now, is going to be pushed by the wireline sector. Obviously, the defense is up dramatically. But we are seeing some decent strength in both of those, and we're seeing some recovery back to growth again in Medical a little bit in the coming quarter, and our Industrial/Commercial sector is doing very well, also.

Any changes to the 10 55 model now?

Touche.

I had to ask that.

We'll settle in with that model and see where we go from here. How's that?

Great job, guys.

Reik Read, Robert Baird & Company .

Just off of that last line of questioning with the cost improvement, and recognizing that this is always continuous, but how much more of this significant cost improvement do you have to go, and understanding that that will create additional flexibility. When do these discussions become more strategic, in terms of driving more business? It seems like it is pretty close.

I would agree with you. It really is, if I am you folks sitting on the other end of this, you're looking at it going, okay, what's '07 and beyond going to really look like? And the discussion is really going to turn to top line growth. I would say there is still some leverage left in the model. Our SG&A line is -- should be -- we should be able to contain it, in terms of its rate of growth relative to the top line, so there is some leverage. I don't think you're going to see dramatic expansion of gross margins any more, because quite frankly, it will be throttled by the marketplace in which we compete.

But will these -- I guess what I am driving at, Dean, is will these additional cost improvements, that may not drive additional margin for you, but it drives additional flexibility, and is that something that in the very near term, creates some additional opportunities for you?

I think it does. I think, you know, we're out there. We're certainly kind of addicted to margin, I would say internally from an operational standpoint. But we're not desperate for margin when we're going out and winning new business. And, we know when we were under duress, we were certainly desperate for margin. When we were winning the business. So we have a little more flexibility when we are competing for new business. And it allows us to be more aggressive, and take advantage of that. So I think it really does offer us a bit of a competitive advantage right now, to potentially gain some bigger chunks of business, as we look for it. We're moving into our season, where we talk to our Board, talk about strategy, talk about acceleration of growth. And we should be able to provide you with a little more clarity on that, as we start to approach the end of the fiscal year.

Okay. And then, Dean, in your comments, you talked about the pipeline expanding to $1.5 billion, with $500 million being near term, highly likely. Can you give us a sense for what "highly likely" means, in terms of a percentage? And then can you give us some sense for the likeliness of that remaining $1 billion?

Well, I think, let me just say that the 2 pieces are kind of how long the opportunities have been in the pipeline. Kind of we look at them, and they move through the funnel, and we stage them as we move along. And some of the $1 billion pieces just kind of earlier, or it may be with customers that we currently have no business. So the $500 million is -- probably 80% of that number is with the existing customer base. And we always say it is more difficult to win a new customer. Once you have the customer, you understand each other. You have expectations that have been set, and it increases the probability of success. Now, I think it would be unwise of me to predict what percentage of that $500 million is going to come home. Although I am tempted to do it just to set a goal for the account management team, so I am going to leave that set. .

Okay. And then just 1 more last quick question. Just with the Medical engineering side, where you're winning so much new business there, and it is 60% of the quarter. Does that suggest, just given that you've seen that in the last couple of quarters, does that suggest the potential for greater acceleration in terms of the manufacturing business, because of those engineering wins?

My expectation is that we're going to get Medical back on a good top line growth path as we start moving through '07.

Okay. Great. Thank you.

Shawn Severson, Raymond James.

Congratulations. Just a couple quick questions. Gordon, on the technology group, was that a meaningful contributor to the margin improvement? Or is it just too small to really chalk too much up to that?

Well, it was only, as I said, it's only about $10 million in revenue. But it internally, it certainly is substantially more profitable this year than it was last year this time. But as I said, it is relatively a small sector of the Company.

Okay. And quickly on the revenue, just kind of a break out on your customer base. Do you have an idea of how many of your customers that say, excluding of course Juniper and GE, but under $50 million in revenue, in terms of OEMs revenue, And just trying to get a sense of kind of the break out of the size of your customer base, outside of the communications market and GE?

That's a hard question to answer just off the cuff, Shawn. Why don't I do some research, and you and I can follow-up off line.

No problem. What's your percentage of box build today?

Well, let's just say that it's probably the combined direct order fulfillment in completed product assemblies, is probably north of -- somewhere in the 45 to 50% range.

Okay. Thank you.

Kevin Kessel, Bear, Stearns.

In terms of the engineering business you just mentioned, Gordon, what would be the rough operating margin of that business? I know it is small obviously, in terms of size.

The gross margin potential in that business is 3 X manufacturing business.

Okay. And obviously, there is a higher SG&A content there. So would you say it's maybe 2 X in terms of operating?

Yes. At least.

You have to be careful about the SG&A content, though, because essentially the engineers are essentially in cost of goods. This is a professional services organization that you would model, not unlike a law firm or a public accounting firm would be, so -- .

So it wouldn't be modeled as R&D, is what you're saying.

That's correct. The engineers are essentially the sales generation engine. They are the productive element of the Company.

I got it. And then my question is, you've gone into a lot of detail on the pipeline for obviously, manufacturing, which sounds very encouraging. What about the pipeline for engineering, you're obviously winning there. And if I recall correctly, this business used to be about 5% of Plexus' sales when it was a smaller company, and now it is about half of that. Is there a big pipeline ahead for engineering business?

Well, there is. I think you might recall a couple of quarters ago, we announced that we made some changes. We had moved to this market sector based strategy, maybe 2 years ago now. Really started to get some momentum in it about 18 months ago. And we were starting to see success for manufacturing, but we had a real trip up here, in terms of the engineering pipeline. And so we started to add some specialized resources into the market sector teams, to specifically focus on winning new engineering business. There was also some changes in responsibility within the engineering organization itself. And that substantially improved the pipeline, and began to increase the win rate for that business. So I think it is fair to say that that problem has been fixed, and we are now starting to generate a nice predictable pipeline, and a nice predictable set of wins for that organization. And really, their constraint right now is resources. We're back to growth and we are right now, short of engineering head count to help create opportunity on all of that growth.

What would the engineering head count be out of the 7,600 you mentioned of Plexus employees?

Head count is right around 400.

Okay. And then, when you think about it, how difficult is it to literally double engineering from 10 million to 20 million? Is that something that takes years to do? Or is that literally something that can happen within quarters, if you hire the engineers?

It is difficult in an organic mode to sustain probably growth rates in probably above the kind of 10 to 15% range. So to grow real, real quickly, you almost have to acquire another operation, but we've got a pretty good recruiting engine. It is just a question of bringing folks on, and getting them trained, and making sure that we don't have any breakage, in terms of quality of the service.

Okay. And are these engineers at all involved in your go-to-market strategy in terms of on the sale side, do they go out there to customers as well, and are very involved, in terms of winning business, on the manufacturing end that is before -- ?

Well, we sell the whole model. So when we go off to customers, and we're trying to win a new customer in particular, we're out there with the whole team. And so it is a team effort, and we leverage that capability to win manufacturing, and hopefully bring in engineering opportunities at the same time.

I got it. And then in terms of net cash, guys, you're now up to $2.37 of net cash, and you did a great job generating cash on the quarter. I know Plexus isn't interested in doing very large scale acquisitions, but what is the appetite for acquisitions today, whether they be niche or engineering focused, or what have you?

Well, Gordon always looks at me with -- .

pleading eyes. May I answer the question.

The topic of acquisitions is obviously a strategic kind of discussion. But I would say that we are not going to get out there on an acquisition binge. But having said that, we also need to consider the global growth of the Company, and where we might need to have a physical presence in order to service the growth of customers in a regional marketplace. And so it is part of our strategies, and we'll work through that through the last half of this year. Not into next year, we will be considering whether or not Greenfield approach, or acquisition approach, is going to be the right approach to enter those new markets.

Great. And have you guys given any thought at all, if you don't do acquisitions any time in the near term, and you continue to build cash, of doing either some sort of dividend or stock buyback?

We're not down the lines of that kind of thinking right now. We think the cash is going to be put to better use to grow the Company.

The last question is just on SG&A, I guess for Gordon. Up, but it seems like probably primarily due to your ERP implementations in the low cost areas. And where do you see that in terms of dollars, going over the next few quarters here, as you continue to bring up sites on your JD Edwards and your Agile?

The SG&A is really -- it's influenced by the JD Edwards implementation. But it is not definitive on the numbers. The SG&A is going to go up in Q3 and Q4. We're looking at slightly higher accruals for variable incentive compensation, and of course, stock-based compensation is going to cost us about $0.02 in Q3, and perhaps $0.03 in Q4.

Thank you.

[OPERATOR INSTRUCTIONS] Carter Shoop, Deutsche Bank.

Good quarter, guys. Wanted to better understand kind of operating profit contribution that we've seen. Over the past 3 quarters, it's averaged roughly 40%, which I find mind boggling. Maybe talk a little bit about the gross margin contribution, gross margins were up roughly 18% sequentially, on a 2% increase in sales. Is there a way we can get a little bit more granular in regards to the components that drove that? How much of that was manufacturing inefficiencies that were able to get out of the system? How much of that is discontinuing relationship with the less profitable customers, et cetera?

Well we're not going to get into the level of granularity you're asking for, Carter. The broad answer is, I thought I addressed in my prepared comments, that we're really seeing the operating leverage in the model. That is, we're driving more production through a relatively fixed expense base. Paul is just doing a great job with these factories. All of our factories, with the exception of the Mexican operation, are profitable, and -- .

So as we go forward, we're going to hit about a 6% operating margin in the June quarter? And you guys are suggesting it is going to max out around that level? Why are we going to see the operating contribution max out at 6% then? We've been doing 40% on very marginal, sequential growth. And now you're saying that we're going to continue to see growth, but instead of 40% operating contribution, we're going to see a 6% operating profit contribution on a go-forward basis.

Well what we tried to suggest, Carter, was that there is a trade-off between further driving incremental operating margins, and generating higher top line growth. And that's what we're currently evaluating, and I think we are going to opt not to drive operating margins, but to go for higher top line growth.

Was it safe to assume, then, that $500 million new business pipeline that you guys are evaluating, has current operating margin potential below the 6% level, then?

No, I wouldn't assume that.

Okay. I am a little bit lost in why margins wouldn't go up more than -- ?

Remember, as we get closer to capacity, the leverage starts to decrease somewhat.

I think we're really saying, Carter, is that you're going to see some throttling of gross margin expansion. We've had just tremendous gross margin expansion, as Paul said, because of leveraging the current investment of fixed costs, in the manufacturing organization. Yes, we can maintain the SG&A to a relatively fixed level. But we think that we're going to continue to bring in business that's going to throttle in at about the current kind of level that we're at.

If that new business comes on at 6%, wouldn't you also realize some manufacturing efficiencies as you get a little bit higher? Or do we see the actual benefit from new business really max out at that kind of 75% capacity utilization rate?

I think that's -- what you're suggesting is correct, in that we're going to hit kind of the point where we're going to have to start adding costs -- fixed costs, into manufacturing in order to expand capacity to take on additional revenues.

Carter, we've talked about expanding the Chinese facility, and probably opening up a new facility in Penang, or somewhere else in southeast Asia. And just as our second facility in Penang costs us a couple of pennies a quarter as it was in a start-up mode, we can expect that same kind of drag on earnings as we bring on new capacity.

Okay. Just 1 clarification on the military customer. I think Steve Fox asked a question, what percentage of that business is ramped, or are we at peak? And I am not sure if I heard the answer there. Are we going to see a full quarter of revenue in the June quarter from that customer, or two-thirds of a quarter? How should we think about that?

We're still in the process of completing the ramp, although, especially the last couple weeks, we're well under way. We talked about that I think last quarter, that the real vertical ramp was really at the back end of Q2, and continuing through Q3. So progress every day in the -- our team is doing a great job of knocking down the issues. Again, we talked about one of our real benefits here is accelerating the speed of transitions, and this is one where we've been able to do that very well.

Okay. So, entering the June quarter, you guys are at full production?

We will be at full production during the June quarter.

During the June quarter.

During the June quarter, and you think of it as kind of that contribution from that, as kind of level as we move forward.

Okay. So we wouldn't see a meaningful pick up from that particular customer in the September quarter?

We are not currently anticipating that, although there are still opportunities for that -- for the demand to rise.

Great. Thanks a lot, guys.

[OPERATOR INSTRUCTIONS] Todd Coupland, World Markets.

Actually my questions have been answered. But nice quarter, everyone. Thanks.

Rich Kugele, Needham & Co.

And congratulations goes without saying. In terms of the defense business, can you give me a little bit more color on how sticky these programs are, and how long they typically run? Does the government typically go and rotate these on a 6 , 9 month range? Or do you expect this to kind of last well into '07?

Well, I would say -- let me acknowledge that the defense kind of military-related business that can be different. Although it is not always different than our other business, but it can be. And in this particular case, it probably is somewhat different, in that it has -- there are fixed kind of order sizes. And then additional order quantities need to be approved further up the food chain, within the government organization. So it is not completely driven by obviously, end market appetite. It is driven somewhat by politics. But at the same time, as we look into '07, we're appropriately anticipating potentially a pull back in the order quantities from this particular program. But we have other opportunities that we are expecting to replace that revenue. But if order quantities continue beyond where we currently have them forecast, it is upside. As we look into '07, we're still suggesting that, as we see this program today, and as we have visibilities into the orders with this current program, it should not be an impediment to us continuing to go grow 15 to 18% in the coming year.

Can you give us a sense on what you target the military business, just in general, as a percentage of your longer term business model?

Well, we haven't at this point, set a specific number on it, because in this year was relatively a new sector for us, and we're still getting our feet wet in terms of success. We certainly will set more of a target for it as we move through the year, and build our fiscal '07 plan. But I don't have a specific number to share with you today.

Just lastly, you are generating obviously, a fair amount of cash. And you talked how you're not planning on dividends or stock buybacks, and you are increasing your CapEx a little bit. But can you cite any verticals that you might want to try and get into in the coming 12, 18 months?

I think right now, I kind of like the verticals that we're in, and we're going to concentrate on getting share in the particular verticals that we're currently participating in.

Okay. Great. Thank you.

Thank you. At this time there appear to be no further questions. I would like the turn the floor back to management for any closing comments.

I just have just a brief comment. I would just like to thank all of you for your support of Plexus. I thank you for the good questions today, and with that we'll say good bye. Thank you.

Thank you. This does conclude your teleconference. Please disconnect your lines at this time, and have a great weekend.