Plexus Corp (PLXS) 2007 Q2 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to the Plexus Corporation conference call regarding its second fiscal quarter 2007 earnings announcement. At this time all participants are in a listen-only mode. After a brief discussion by management, we'll open the conference call for questions. The conference call is scheduled to last approximately one hour.

I would now like to turn the call over to Kristian Talvitie , Plexus Vice President, Marketing, Branding and Corporate Communications.

Hello, and thank you for joining us this morning. Before we begin, I'd like to establish that statements made during this conference call that are not historical in nature are forward-looking statements. Forward-looking statements are not guarantees, since there are inherent difficulties in predicting future results, and actual results could differ materially from those expressed or implied in the forward-looking statements. For a list of major factors that could cause actual results to differ materially from those projected, please refer to the Company's periodic SEC filings. The Company provides non-GAAP supplemental information, typically earnings and EPS excluding restructuring costs, charges for the impairment of goodwill and other long-lived assets and adjustment to the valuation allowance on deferred tax assets. All comments concerning earnings comparisons on this call will refer to non-GAAP earnings. For a full reconciliation of non-GAAP earnings to GAAP results, please refer to yesterday's press release and our periodic SEC filings.

Joining me this morning are Dean Foate, President and CEO, and Gordon Bitter, Senior Vice President and Chief Financial Officer. But quickly before we begin today's call I'd like to remind everyone that we're hosting our investor day on June 7th in Neenah, Wisconsin, which will include discussions with management, as well as facility tours. Please feel free to call or e-mail me directly to RSVP or with any questions regarding the event. Also, please remember to make your room reservations prior to May 6th because of block we have reserved will open up at that time. We'll now begin today's call with Dean making some brief comments about the quarter and on the outlook for Q3 and the remainder of fiscal 2007. Gordon will follow up with the details on the financials, and we'll then open the call up for questions. Please limit your questions to one question and one follow up.

Let me now turn the call over to Dean.

Thank you, Kristian, and good morning, everyone. Last night we reported results for our second fiscal quarter. Revenues were $360 million, above our guidance range for the quarter. Our GAAP EPS was $0.22, significantly better than our guidance. Our second quarter performance was better than expected due to a number of factors that Gordon will outline in a few minutes, but let me briefly comment on a couple of key drivers. First, revenues were significantly better than expected, as 16 of our top 20 customers improved their forecasts as we moved through the quarter.

Second, as I'm sure you gathered from the press release, our core operating results were, in fact, much better than the upside to earnings that we ultimately delivered. Our revenues and margins were significantly diminished due to an unexpected and disappointing difficulties with a newer account. Earnings leverage was substantially better than anticipated and had therefore begs comment. When we provided our second quarter guidance we were in the heat of the battle coming off a few weeks where customers across all market sectors were backing away from earlier forecasts. As we progressed through the quarter, our operation teams executed extremely well, confidently adjusting our cost structure in light of lower revenues. Our Q2 guidance reflected a prudent and conservative range. At the time of the earnings release we simply could not be assured that all of our cost-containment measures would be achievable during the quarter. The improved leverage highlights the quality of our operations team, their disciplined management processes and decision support tools. I believe they did an excellent job resetting our cost structure in light of the unexpected and rapid decline in revenues. Perhaps the key take away is that our operating model goal, which we refer to as our 1055 model remained intact.

Let me continue by providing a few details about our second quarter, third quarter, and full-year outlook. Looking first at our performance by market sector. Our Wireline/Networking sector was flat sequentially in our fiscal second quarter. We had anticipated revenues to decline. The renewed strength of reasonably broad based, as several leading customers improved their earlier forecast during the quarter. While the outlook in the third quarter for most of our customers in this sector is weak, we currently are projecting modest growth, largely driven by demand indicated by a leading customer and the ramp of programs with two new customers. Our Wireless Infrastructure sector was down this quarter as expected due to end-market weakness in a few accounts. Our third quarter outlook is uneventful as we currently expect sequentially flat performance. While down significantly, our Medical sector performed somewhat better than expected in Q2 as a few accounts improved earlier forecasts. Overall weakness in Q2 reflects general end-market demand challenges, some seasonal weakness, product transitions to lower-cost technology, and FDA issues facing certain accounts, all in all not pretty. We expect the turbulence to continue in our third quarter. We are currently forecasting a mid single-digit decline in revenues. We currently expect to reverse this trend in our fourth quarter.

Our Industrial/Commercial sector was weaker than expected in Q2. The difficulty was broad-based with ten of our top 15 accounts down in the quarter. We currently expect Q2 results to be flat. Results -- or revenues in Defense, Security and Aerospace sector contracted in Q2, as production orders for our largest defense accounts stalled. As indicated in yesterday's press release, very late in Q2 we secured additional purchase orders for this account. We expect to fulfill these orders during our third and fourth quarters, with a small carry-over into fiscal Q1 of next year. While our policy is not onto guide specific revenues for specific customer programs, we acknowledge the unusually lumpy and material impact this program can have on our results. Relative to our second quarter, this program should deliver about a 50% increase in our Defense sector revenues in Q3. Relative to Q3 Defense sector revenues should more than double in Q4. While the fourth quarter increase is largely driven by this leading account, the increase also reflects growth with a couple of other accounts.

Looking ahead to fiscal 2008, we have very little visibility into potential orders for our larger defense account. While the opportunity for additional orders stands, we would advise modeling our business without a continuation of orders beyond the very limited production in our fiscal Q1. Addressing our overall revenue concentration, revenue from our top ten customers represented 59% of our total revenues this quarter, about the same as last quarter. Juniper Networks represented 19% of the total, the same as last quarter. Our business with GE, inclusive of multiple GE divisions, represented 10% of total revenues, down from 13% last quarter.

Turning now to new business wins, not including the purchase -- the follow-on purchase orders for our larger defense customer, during the period we won 13 significant new manufacturing programs, which in total will add approximately $100 billion in annualized incremental revenue as these programs begin to ramp in the second half of 2007 and on to fiscal 2008. The majority of program wins will increase our share with current customers, the remainder under new customer wins. Our funnel of opportunities remains very healthy at $1.6 billion of qualified new business, somewhat up from last quarter. We continue to balance our growth by pursuing increased share with existing accounts, while adding new strategic growth accounts to our sector portfolios. In the Engineering Services front, we won over $10 million in product development business during the quarter, a level sufficient to sustain a very healthy backlog. During the quarter our Engineering Services business was operating beyond capacity, a condition we we haven't experienced since the dot com era.

Addressing capacity utilization and global growth investment, our [inaudible] capacity utilization was approximately 67% overall as we exited the second quarter, down from 75% last quarter. The decline was in part a consequence of lower sequential revenues, but the greater impact was driven by continuing capacity investments at our facility sites -- or our manufacturing sites in Asia. Turning now to our guidance, we currently expect our third quarter revenues to be in a range of $365 million to $375 million with EPS, excluding any restructuring charges, in the range of $0.25 to $0.30, which includes approximately $0.03 per share of stock-option expense. We are revising our full-year revenue growth target to the range of 6% to 8%, implying a stronger second half to our fiscal year, but also reflecting the revenue downside with the troubled account mentioned earlier, as well as our cautious stance in light of continued weakness of customer forecasts and the slower pace of newer program ramps.

With that, I would like to turn the call over to Gordon to discuss the details of the numbers. Gordon?

Thank you, Dean, and good morning, everyone. Before getting into the fiscal second quarter numbers, let me spend a few minutes addressing why we exceeded our earlier guidance. The mid point of our earlier guidance for the quarter was for EPS of $0.17, and we came in at $0.23, excluding about $0.01 for restructuring costs. There are really four factors that led to the $0.06 improvement in earnings per share. First, as Dean has already mentioned, our revenues came in ahead of our earlier expectation and higher revenues contributed about $0.04 to improved earnings per share. The second factor, which Dean has also mentioned, is cost reduction and improved operating efficiencies, which together contributed about $0.10 to higher EPS in the second quarter. The third factor, unfortunately going the wrong way, was the $5.9 million inventory writedown that was made necessary by the financial difficulties of one of our accounts. This writedown cost us the equivalent of $0.10 per share in the quarter. The final factor was a lower tax rate. The tax rate for the second quarter was only 15%. We had previously anticipated a higher tax rate of 23%. The lower tax rate contributed about $0.02 to improved EPS this quarter. I'll revisit the tax rate discussion later this morning.

Turning now to the second quarter numbers, I will take two shots at it. First versus the prior quarter, that is the first quarter of fiscal '07 and then versus last year's second quarter. Turning first to the second quarter of '07 versus the first quarter of '07, revenues declined as we had anticipated due to across-the-board sluggish demand caused in part by inventory adjustments for several accounts. Reported gross margins were only 8.8%, down 160 basis points from the first quarter's 10.4%. Operationally, that is before the $5.9 million writedown of inventories, gross margins would have been 10.4%, the same as Q1. As noted earlier, our manufacturing sites and our engineering business unit performed superbly this quarter. SG&A expense was essentially flat with the prior quarter, as we carefully controlled spending in view of the anticipated downward shift in revenues for the second quarter. The $419,000 of restructuring costs in the current quarter was to adjust staffing levels at the Kelso, Scotland, and the Juarez, Mexico facilities. Unfortunately Mexico's operating loss widened in the current quarter to about $1.8 million from last quarter's $1.4 million. Slower-than-expected new business for this site will delay attainment of break-even performance beyond the current fiscal year. Operating margins slipped to 3% from the last quarter's 4.9% primarily because of the writedown I've already mentioned.

There's not much to comment on below the operating income line until we get to the tax provision. We currently estimate that our effective tax rate for the year will be about 20%. This is down from the 23% that we had estimated and applied for the first fiscal quarter's results. Adjusting the year-to-date income statement for a 20% effective rate arithmetically results in an effective 15% tax rate for the second quarter. The lower tax rate currently expected for the year, that is the 20% rate, is due to a now anticipated lower percentage of pretax income in the United States as opposed to Asia, where we currently have tax holidays.

Let me shift now and review the second quarter versus the second quarter of fiscal '06. Revenues in the current quarter were up $22.3 million or about 6.6% from the year-ago quarter, mainly on the strength of the Wireline/Networking market sector. All of the other market sectors were flat to down due to generally weaker end-market demand. Gross margins in the current quarter at 8.8% were seriously below the prior year's 11%. Obviously the $5.9 million write-off in the current quarter didn't help. But beyond that, our manufacturing sites and our engineering sites ran much more efficiently in the current quarter, although a less favorable mix of customers in the current quarter largely offset these improved operating efficiencies. The start-up losses in the current quarter for our third facility in Penang were about $700,000, which is kind of where we expected. I expect the new facility to become profitable late in the fiscal third quarter and to operate profitably in Q4. SG&A expense increased by $1.3 million or 6.6%. This was mainly due to increased spending for more resources to support sales and business development. And operating margins for the second quarter were only 3% versus the 5.2% achieved in the comparable prior-year period. There were no restructuring costs in last year's second quarter.

Below the operating income line net interest was favorable to the year ago period. We amended the credit agreement with our bank group very early in the fiscal second quarter of '07 and that lowered the commitment fee that we pay on the unused balance and extended the period for amortizing the origination fees. And, of course, we're operating with higher cash and investment balances in a higher interest rate environment than in the prior year, so our interest income was higher this year. Pre-tax income was $6.6 million below last year for the reasons that we've already discussed, and once again the after-tax comparisons are even more difficult because last year at this time, we weren't tax effecting pre-tax income in the United States because of the valuation allowance on the U.S. deferred tax asset that we had at that time. This year in the second quarter we faced an overall 15% effective tax rate, so the variance at the net income line is even wider, $8.4 million.

Let me turn to the balance sheet and cash flows. Candidly this was not a great quarter for balance sheet metrics. As you saw in the press release, days and receivables during the second quarter extended by three days from the prior-quarter balance. There is nothing unusual here, just some timing issues on receipt of payment at the end of the quarter. Days in inventories extended by five days. Two factors drove the deterioration. First, putting inventories in place for anticipated higher production levels in the second half and, secondly, increased finished goods inventory maintained for several customers to enhance their flexibility and responsiveness to upticks in demand.

Accounts payable did improve by three days during the quarters, so the overall cash conversion cycle extended by a net five days. I am, however, anticipating improvement in each cash cycle metric in the second half of the fiscal year. Cash flow from operations was approximately $11 million, in contrast to the deficit that we ran in the first quarter, and the positive cash flow in the quarter was driven primarily by earnings. I anticipate much higher cash flows from operations in each of the remaining quarters in fiscal '07. Capital spending for the quarter was $16.2 million and depreciation expense was $6.5 million. I should also mention we had cash proceeds of about $4.5 million from the disposal of our former site in Malden, England. We're still expecting capital spending for the year of around $70 million.

With that let me turn it back to Dean.

Thank you, Gordon. While I am disappointed with our projected growth performance this year, I am encouraged by the strength of our operating model, our increasingly competitive global capabilities and the pace of new business wins that should drive stronger top-line growth in fiscal 2008. We continue to make progress on key initiatives, a few highlights. Our capacity investments in Malaysia and China are progressing i as planned. During the third quarter, our Boise and San Jose facilities are -- begin operating on our common global ERP platform, leaving only one manufacturing site on a legacy system. Our Engineering Services business delivered through Plexus technology group is enjoying new strength. Our engineering leadership team is adding head count to it's global footprint. We're driving a lean sigma culture throughout our organization; the benefits are evidenced in our performance. We still anticipate that our full year after-tax return on invested capital will be above our weighted average cost to capital.

Kristian?

Okay. With that we're getting ready to open the call up for questions. Again, quick reminder. Please keep them to one question and one follow-up question. Operator?

(OPERATOR INSTRUCTIONS) Your first question is coming from Amit Daryanani of RBC Capital Markets. Please go ahead.

Thanks. Good morning, guys.

Morning, Amit.

Just a question on the Defense business, so I get it squared away. You're expecting about $10 million in June, $40 million in September and it starts to fall off after that side of the March quarter, is that a reasonable way?

Well, we tried not to characterize it in terms of specific revenue numbers, and like I said, I tried to give it to you relative to what the current revenue run rate was for in Q2 for our Defense sector so you should look to that sector, as I said, to go up about 50% in revenues. And if you look at Q4 relative to Q3, we should -- you should expect revenues to more than double again in Q4 overall for the sector.

And then Q1, does that kind of go back to half the size of the Q4, the Defense segment?

Yes, I think if you looked at Q1 of fiscal '07 and use that as a gauge for what we would expect in '08, at this point it's a reasonable estimate at this time.

Okay. Just the margin profile in the defense program, is it similar to what you guys had in back in '05 when it ramped?

The margin should be similar to the margins we enjoyed in fiscal '06, Amit, yes.

All right. So the 1055 model on a core basis and you get a little extra kicker out of this model -- out of the defense program for the next few quarters then, right?

That's a good way to look at it, yes.

And finally, you talked about a troubled account, $5.9 million you had to take -- the $5.9 million charge for it. How big was the account in terms of sales for you that you're backing away from your guidance essentially, that you're taking out of your full-year guidance?.

I don't want to get into the specifics of it, Amit. It was a fairly new account for us. It was not a major contributor to our revenues, but it was expected to become a fairly significant account.

All right. Thanks.

Thank you. Your next question is coming from Tom Dinges of JPMorgan. Please go ahead.

Hi, good morning, guys. Dean, I wanted to touch on one of the topics you talked about where you were talking about your engineering group basically running beyond capacity and you're talking about adding head count. Can you talk about, perhaps, how much head count you're talking about adding and how quickly you get those folks to where, in the consulting jargon, they're billable -- fully utilized or utilized to the point where they're actually contributing to the profit line> And then I've got a quick follow up for you.

I think in general we're looking at probably a 10% increase here in head count as we move through the year within technology, but I would say that the contribution in terms of revenue and profitability is not all that material to Plexus overall. It certainly is material to the engineering organization, and it typically takes maybe 50% of the year where they're still in training and contributing somewhat and a full year before they're fully contributing meaningfully to the engineering organization in terms of its growth and profitability.

Okay.

I would say this, we are looking to hire at most of our facilities across the world, but the most of the hiring will takes place at our design center in Penang, Malaysia.

Okay, and then I wanted to get a little bit more detail on your characterization of the expectation in Medical, especially as you talked about in the fourth quarter, because you're seeing, as you said, a small sequential decline this next quarter but expecting to see some things bounce back in the fourth quarter. And from what you can see now, because obviously a lot of moving parts as you talked about product transitions, FDA issues and so forth, but can you characterize it better? You're expecting to get that sector back to a double-digit increase or what's the expectation that you're thinking about there, because you had roughly about, call it $90 million this quarter, do we get back above that level in the fourth quarter or is it still going to be below that?

No, the hope is that it will come back up to about the second quarter number in Q4, maybe a little north of that, but there's quite a bit of uncertainty there yet because of the nature of some of the delays.

Okay. Thank you.

You're welcome.

Thank you. Your next question is coming from Steven Fox of Merrill Lynch. Please go ahead.

Good morning, Steve.

I believe his line may have disconnected.

He changed his mind.

Your next question is from Shawn Harrison of Longbow Research. Please go ahead.

Good morning.

Good morning, Shawn.

First question just has to deal with the margin profiles as we head into the third quarter. If my quick math is correct, it looks like either operating expenses jump up a little bit or you see a small degradation in gross margin. If you could just help me out with the math?

Yes, let me see if I can, Shawn. As I mentioned during the conference call, if we take out the $5.9 million writedown of inventories, we had gross margins about 10.3%, 10.4%. I would see those gross margins in the third quarter coming down a little bit despite higher revenues. The key reason for that is that there's a lot of change going on among our various programs. The programs that are increasing -- that result in the net increase and expected revenues in the third quarter are basically less profitable, so you could say there's an unfavorable customer program mix anticipated in Q3 that will bring down adjusted gross margins.

I just want to emphasize you're saying it is down from what the performance would have been.

Yes, down from the 10.3% that it would've been, I think I said.

Correct. And assume OpEx is pretty similar with the prior quarter?

It'll be up a little bit, I would expect, Shawn, but nothing very significantly.

Okay. Then if you could just give a little color in terms of the end markets where the new programs were won in the second quarter, and then additionally, just color on the end markets associated with that $1.6 billion pipeline?

I would say the pipeline is reasonably balanced, I'll start with that. We continue to do a good job with our sector-based go-to-market strategy here, so the overall funnel is nicely balanced across all of our sectors, with the exception of Medical, where we've had really strong performance in our engineering organization. And we're starting to see some additional traction here in our Defense, Security and Aerospace with the engineering organization, as well, in terms of new wins and in terms of the pipeline, so decent traction there. New wins, I didn't break them out by individual sector. As I glance across the list, I think we closed some business in every one of our sectors during the quarter, so pretty good performance I would say.

Okay. Thank you very much.

You're welcome.

Thank you. The next question is coming from Steve Fox of Merrill Lynch. Please go ahead.

Hi. Good morning. Can you hear me?

Yes, we can, Steve.

Okay. I don't know if this question got asked in the meantime, but ask can you go back, looking at your SG&A performance how much of that can you carry over into the next few quarters? You mentioned increasing your head count, but keeping it in the $20 million to $21 million range, is that feasible for the rest of the year?

Ye, I would expect some very modest growth in SG&A for the remainder of the year, but we've got some pretty good cost controls that account.

And then the defense program, qualitatively can you talk about how profitable it is relative to the previous big program you had? Is it similar?

We did touch on that, Steve. I mentioned that it will have a similar profit profile as the revenues we enjoyed in fiscal '06 for that program.

And then lastly, just looking out at how some of the businesses ramped, you mentioned some disappointments in programs ramping. When you look at how -- some of the wins you've had over the last year, year-and-a-half, can you talk about how much you've had to deal with pushouts relative to when the customers have said they would start ramping, et cetera, because you continue to talk about new wins, but I'm just trying to gauge how much we should discount that as we look into next year?

Well, it's a very good question because I think if you look -- if you stack up how we performed last year, when I announced new wins, you had a clear delivery of that revenue to our overall performance. And this year we've had a -- what I would say is a very good pace of actually closing business, but the disappointment is it hasn't been delivered to the top line; in part because you're seeing some degrading of the existing programs in terms of the strength of the existing programs, so you're not seeing the effect of the newer wins. And also the new wins have been somewhat diminished, like existing programs, in terms of their overall run rate. So it's been some of an anemic performance relative to the pace of the business development teams bringing in the business. So I would hope -- it's hard to characterize what's going to happen as we move through the back end of the year and into '08, but I would hope that this is somewhat of just a tech market squeeze here and that we're going to see some better performance as we start getting into '08. But there's certainly no guarantees that the numbers that we're getting from the customers with new program wins are actually going to be fully delivered.

Thank you very much.

You're welcome.

Thank you. The next question is coming from Kevin Kessel of Bear, Stearns. Please go ahead.

Thank you. My question is on inventory. The last quarter you guys were mentioning various inventory corrections happening across the board at different customers, can you give us an update on where that stands today?

Your question is more about the channel inventory and delivery to our customers rather than the supply side?

Right.

Yes. You know, it's difficult for us to get full visibility based on the breadth of different products that we manufacture and because many of them, of course, are still at subassembly levels, but I would say if you look at that -- what is affecting us, certainly inventory correction within the channel within some of the customers is certainly a part of the equation here and it's been a material -- was a material impact last quarter and I would say it's still working its way out as we move through the quarter. Now hopefully we're going to start to see that pull through in the later half of the year, but it all depends on the health of the end markets for our customers. Certainly there is a channel backup here with some of our customers that they're trying to get cleared.

Okay. And then you mentioned earlier that the defense program you thought would be of similar profitability in terms of the way it looked relative to the last one, but in terms of overall revenue size, does that also sound like it's going to be relatively similar to the last time, the last program?

That's a fair approximation I think, Kevin.

Okay. And lastly housekeeping, stock option expense in the quarter?

It was $1.3 million, of which $900,000 was in SG&A, and the balance was in cost of sales.

Thank you.

You're welcome.

Thank you. Your next question is coming from Yuri Krapivin of Lehman Brothers. Please go ahead.

Good morning.

Morning.

Well, my first question is on the facility in Malaysia. What do you expect capacity utilization at that facility to be by the end of that fiscal year?

I think first of all, Yuri, it's important to know that we talk about capacity utilization on what we call an as-tool basis. This is a fairly large, nearly 400,000 square foot facility, and it's going to take us some time to get it to practical capacity. Right now I think there are three lines up and running, and if you just measure capacity against those three lines, it's probably 50% or less right now. But the revenue is there. The production there is expected to expand pretty rapidly.

Okay. Then with respect to cash flow, Gordon, you mentioned that you expect operating cash flow to improve significantly in the second half of the year. I believe your previous free cash flow guidance for the year was neutral free cash flow. Is it still the outlook for free cash flow?

Yes. Let me just state it differently, Yuri, because there are all kinds of different definitions and subsets on cash flow. We expect strong cash flow from operations in the second half, so that by the end of the year our cash flow from operations should actually meet or slightly excleed -- exceed the $70 million we expect to spend on CapEx. Or stated differently, I would expect that our cash and investment balances at year-end '07 will be about the same as they -- or maybe a little higher than they were at fiscal -- at the end of fiscal '06.

Thank you. And finally, with respect to this larger military program, so you're advising us not to model additional revenues in fiscal '08. Is it just pure conservatism on your part or are there any indications from your customer that this program may actually not repeat next year?

Yuri, it's just -- this program, as we describe it, is very lumpy and the quarters in which we have this program it feels great, and then the quarters in which we don't have it, it doesn't feel so great. I guess what we're trying to do is encourage to you look at Plexus on an ongoing basis without this very large program, maybe put back some option value to the value of Plexus based on this program, but it is so lumpy and it is so difficult to forecast.

That's fair. Thank you very much.

You're welcome.

Thank you. Your next question is coming from [Ray Creed] of Robert Baird & Co. Please go ahead.

Good morning. Dean, in your comments it sounds as though the Medical and the Industrial segments are the one that is bring at least particular concern to you right now. Can you talk in a little more detail about what you're seeing in each one of those segments and when you start to think that some of those issues ebb from here?

Well, the Medical sector right now is being impact the by a number of factors that I attempted to outline, and part of it is just with our -- as you know, when we look at our fiscal first quarter, historically we've had quite a strong performance in Medical in that quarter for whatever reason, so it has been somewhat seasonal in the first quarter with a particularly large customer there. And typically we see quite a bit of back off on that as we entered fiscal Q2, and that in fact happened again this year. We also have some product transitions that are going on, where our volumes are staying relatively level with certain technologies, but there's a new -- essentially a lower-cost unit-cost technology, so average selling prices are coming down on a pretty significant program.

And then the third thing is FDA-related issues that are not only holding up production and some growth of production with certain products, but also is got the customer quite distracted from being able to introduce and develop and launch new products because everybody -- it's a fire drill. Everybody's trying to take care of this FDA-related issue before business returns to normal, so that is causing us turbulence in Medical. We expect, as I said, Q4 to hopefully come back to roughly Q2 levels or maybe a little better, somewhat based on stabilizing of revenues from the customers that are having difficulty and also as a result of some new customer and program wins that we believe will begin to ramp in the fourth quarter. So we think Medical's going to be back to trending up here as we come through Q4, and if the FDA-related issues, those things clear up quicker, then great.

Industrial/Commercial is a very mixed bag of customers. It's a very broad sector for us, lots of customers, and I think is a reasonable indicator of industrial kind of commercial technologies and really what the broader marketplace is doing there. We looked at Q2. If we look at our top 15 customers in Industrial/Commercial ten of the 15 were down. If we look at Q3, it is about an even split where we see about eight of them that are going to be somewhat flat to up and others are going to be down. So it's really an overall mix performance and really, I think it's just a consequence of end markets and channel inventory and all kinds of issues like that we're trying to work through. And I don't know how to characterize it any more specifically than that.

Okay. And then just, Gordon, on the DSOs and inventory turns you talked about as part of your remarks, but seems like those have been trending in a little bit more of a negative direction for the past several quarters. Can you just talk a little about what's happening there through time and what some of the major things are you need to do to get that back on track?

Yes, it's a little difficult to explain, but on the inventory side we've had some pressures from some customers for us to maintain additional finished goods inventories to support their possible upticks in demands, which I talked about. There's also -- there was some slippage on the accounts payable side, but I think we've got some programs in place that will bring that back, and as I mentioned earlier, I do expect improvement on both the inventory and the accounts payable side in the second half.

I'd like to just weigh in on this a little bit, because we do get sometimes compared in terms of our overall task cycle performance to some of our peers who operate with very different models. And not to say that we're hitting on all cylinders here, we certainly aren't and there's a lot of opportunity for improvement, but really part of our model is to provide a higher level of service to our customers, a higher level of flexibility to our customers. And as a consequence of that service model we are going to have a different cash cycle performance than our competitors. Now, hopefully, of course, we're getting the return on that investment through higher margins and, of course, ultimately we try to run the Company and try to price business and create the inventory models and margin models based on a return on invested capital model, which we've been able to deliver. So I think -- I'm trying to make a point here that you shouldn't expect us to drive it all the way to the performance that we see some of our higher-volume competitors drive their cash cycles to, and -- but you should expect us to improve.

Thanks.

You're welcome.

Thank you. Your next question is coming from Will Stein of Credit Suisse. Please go ahead.

Good morning. Thank you. I was hoping we could talk a little bit more about the Medical space. I think last quarter you highlighted some double ordering that went on from customers. This quarter the results come in a little better than expected. First, I'm wondering if we still think that there was double ordering or did it turn out that that was real demand? And then I have a follow-up.

Well, there's no question there was a forecasting error that caused us to inflate demand on behalf of the customer, so the customer had a misqueue and essentially loaded too much demand to us, so there's no question that happened. I don't believe that that is going on at all now, but we're seeing some of the results of that of course.

Did their forecasts eventually catch up to what they had over ordered or are we still seeing a work through of that inventory?

It is my understanding that we're reasonably through -- it was largely around one particular program, and my understanding is we're pretty much through that now.

Okay. Then the follow-up is about the FDA comment you made. I'm wondering -- we heard similar comments from one of your peers yesterday, and I'm wondering if there is one customer where this is happening, if it's a significant problem perhaps across more than one EMS company, or if it's maybe the FDA getting more aggressive with medical electronics manufacturing generally and it's affecting more than one OEM? Any comments around that would be helpful. Thank you.

Yes, I guess we thought we invented that excuse, but somebody else beat us to the punch yesterday. I have a sense of the -- of course, who the competitors customers are. My sense is that the FDA-related issues that they're experiencing are not with the same customer, and so this is -- I think the FDA is certainly beginning to understand the model, I think, in the industry and is perhaps getting somewhat more aggressive, but I think they're doing what they need to do in order to make sure that everybody is building product appropriately. So I don't know that there's any -- necessarily any thread of relativism here between what we're experiencing and what our competitors are experiencing, other than the FDA is involved.

Will, if I could just add something, too, because there seems to be some confusion on the part of the some of the analysts. It is not a problem -- not an FDA problem at our facilities. It's our customers facilities that are having the FDA problems. We're fine.

And it's something with traceability of components, is that right? Lot traceability, or is that not correct?

Well, as I understand it, it's more about making sure that product is being built according to the -- what were the audited processes to the audited documentation, and then there was some misqueue in terms of documentation control and the manufacturing processes that turned up difficulties, but we're not getting complete visibility. And, of course, the -- when the FDA finds a problem, it's not unlike when the tax man finds a problem. They start looking everywhere, and so they start doing a very thorough review of everything. And of course, the customer is doing the right thing. They're trying to get ahead that and they're going across all their product lines at various facilities and make sure that they don't have similar problems elsewhere, which is somewhat causing the stall that we're seeing with over-all programs.

I guess what I don't understand is if it's a problem with manufacturing and you guys are manufacturing the product, what is the customer doing? Or is it something with assembly after you guys do your part of it, you send your assemblies to the customer, and they're not tracking something on their end as well as they should, or any kind of color that gives us confidence that the problem is clearly not with you guys and instead is with the customer would be helpful?

Yes. Well, first of all, if the problem was with us, you could go to the FDA's website, and it would clearly appear there, because we are FDA audited and registered in our manufacturing processes is for certain products. It would be a public disclosure that would give us a significant black eye, and that, of course, has not happened. I think the way to look at this is we do not build finished product for all Medical customers, all programs. We do build some finished product but not all the product we build is finished. Much is subassemblies, and so we ship those subassemblies to our customers, who then complete the assembly of products and configuration of products and sometimes leading software and other things. There is some sort of a process -- manufacturing process related, documentation-related process, tracking process problem that the FDA has uncovered.

Great. Thank you very much.

You're welcome.

Thank you. Your next question is coming from Jim Suva of Citigroup. Please go ahead.

Great. Thank you very much. Can you talk just a little about this inventory writedown? Was the inventory actually sold or disposed of, whether it be through a distressed broker or something like, or is this more of a reserve where potentially it's still sellable and it was just an accounting item?

Well, the accountants will tell me not to call it reserve, because what we've actually done, Jim, is written it down to a zero value. It's inventory we had on our books. We continue to work with this account. We hope that they do find additional external financing. If so, then this inventory would be sold to them on a cash basis going forward, and it would be a very high-margin business because the cost of sales would be written down to zero.

Right. So it is potential to come back. And then on that same notion, is it because the customer is going through -- you mentioned the words financial distress or bankruptcy-type nature, or is it because of, like inventory build, where the demand just fell off, because my understanding is you guys don't speculate on building above orders, so if you can just clarify that?

Jim, I think we have to be very careful not to provide any specific comment on the customer's difficulties. I think the best way for you to look at this is they did run into these difficulties. That meant that we had an inventory problem, some of which was finished product, some of it was material. Of course, we took the appropriate financial action. We are working to push whatever unutilized raw material we can back to the supply chain partners and dispose of it properly, but we're also maintaining a relationship with this customer. Their hope is that they're going to need the demand for the finished product and we'll be back manufacturing product again in the future, but there's just no certainty that will happen. So we're taking an appropriately conservative stance financially, but we're not -- we're certainly not at the pointed where we're calling it game over.

Great. Thank you very much.

You're welcome.

Thank you. (OPERATOR INSTRUCTIONS) Your next question is coming from Brian White of Jefferies. Please go ahead.

Yes, bood morning. On the inventory customer, you expect to recognize revenue in the June quarter from this customer?

We don't expect it, Brian. As I said, this company has a liquidity issue they've got to work through, so we certainly are not contemplating any revenues in the June quarter.

Okay. And just on the FDA issue again, you talked about the FDA's better understanding the model. What are you referring to exactly, the outsourcing model?

Yes.

Okay. And has that this any impact on your engineering work?

I guess I just don't know precisely the answer to that. I would suspect that it could potentially hold up programs, but so far we haven't seen that.

Okay. And just on the new cust -- or on the 13 wins in the quarter, how many of those are with new customers?

I think it was just a little under half.

Okay. Thank you.

Thank you. Your next question is a follow-up from Will Stein of Credit Suisse. Please go ahead.

Thanks, just briefly on the customer for whom you wrote down inventories. Can you tell us the end market, please?

I really would rather not, Will. This is a company that's facing some difficulties. The less discussion about it probably the better for them.

All right. Thank you.

Thank you.

Nice try.

There are no further questions at this time. I'll now turn the floor back over to management for any closing statements.

All right. Well, I'd just like to say nice job on behalf of all the Plexus people. They did a really good job executing this quarter is what was really shaping up to be a very difficult situation and just really a spectacular job in light of that. I want to thank all of the analysts for calling in and investors calling in today. I appreciate very much your support of Plexus. Have a nice day, everyone.

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

Thanks, Henry.

You're welcome.