Plexus Corp

NASDAQ:PLXS

Earnings Call Transcript 2020-Q2

[Operator]

Good morning, and welcome to the Plexus Group Conference Call regarding its Fiscal Second Quarter 2020 Earnings Announcement. My name is Sidney, and I'll be your operator for today's call. 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 one hour. Please note that this conference is being recorded.

I would now like to turn the call over to Ms. Heather Beresford, Plexus' Senior Director Communications and Investor Relations. Heather?

[Heather Beresford, Senior Director, Communications & IR]

Good morning and thank you for joining us today. Some of the statements made and information provided during our call today will be forward-looking statements as they will not be limited to historical facts. The words believe, expect, intend, plan, anticipate and similar terms often identify 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 factors that could cause actual results to differ materially from those discussed, please refer to the Company's periodic SEC filings, particularly the risk factors in our Form 10-K filing for the fiscal year ended September 28, 2019, as supplemented by our Form 8-K filed with the SEC yesterday and the Safe Harbor and Fair Disclosure statement in yesterday's press release.

Plexus provides non-GAAP supplemental information such as ROIC, economic return and free cash flow, because those measures are used for internal management goals and decision-making and because they provide additional insight into financial performance. In addition, management uses these and other non-GAAP measures such as adjusted operating income, adjusted operating margin, adjusted net income and adjusted earnings per share to provide a better understanding of core performance for purposes of period-to-period comparison. For a full reconciliation of non-GAAP supplemental information, please refer the yesterday's press release and our periodic SEC filings. We encourage participants on the call this morning to access the live webcast and supporting materials at Plexus' website at www.plexus.com, clicking on Investors at the top of that page.

Joining me today are Todd Kelsey, President and Chief Executive Officer; Steve Frisch, Executive Vice President and Chief Operating Officer; and Pat Jermain, Executive Vice President and Chief Financial Officer.

Consistent with prior earnings calls, Todd will provide summary comments before turning the call over to Steve and Pat for further details.

Let me now turn the call over to Todd Kelsey. Todd?

[Todd Kelsey, President and Chief Executive Officer]

Thank you, Heather, and good morning, everyone. Please begin with our fiscal second quarter results on Slide 3.

After the close of the market yesterday evening, we reported results for our fiscal second quarter of 2020. We achieved quarterly revenue of $767 million.

While our revenue result was below our expectations entering the quarter, I commend our teams and their ability to mitigate the impact of Covid-19-related supply chain constraints, and government mandated workforce reductions at our facilities in Penang, Malaysia.

Our sites in Malaysia operated with 40% of typical workforce for the final three weeks of the quarter. With the exception of our China sites in the month of February, the remainder of our facilities operated near full capacity for the quarter.

While each of our locations face challenges resulting from the Covid-19 pandemic, our talented and dedicated team members at all locations remain committed to meeting the essential needs of our customers and communities.

We delivered GAAP EPS of $0.43 including $0.19 of stock-based compensation expense, and non-GAAP EPS of $0.61 excluding $0.18 due to the previously announced closure of our Boulder Design Center. Both our GAAP and non-GAAP EPS included $0.14 of cost directly related to the impact of Covid-19.

Please advance to Slide 4. While our results were impacted by the Covid-19 outbreak, our teams demonstrated their ability and resolve to overcome the complexities and challenges of Covid-19. They remain committed to delivering for our customers and helping to create the products that build a better world.

Our efforts supported our Healthcare/Life Sciences customers and healthcare workers around the globe by delivering critical medical products that are in the frontline of the battle against Covid-19. This includes products such as infusion pumps, portable ultrasounds, medical bed electronics, portable patient monitors, ventilators, mobile radiography electronics, and diagnostic test systems.

In addition to supporting the fight against Covid-19, Plexus continues to produce products for our Industrial/Commercial, Aerospace and Defense and Communications customers as these products support the essential infrastructure needs of our communities.

Please advance to Slide 5. Next I will further the impacts of Covid-19 and highlight our response in meeting the needs of our team, our customers and our communities. Given our sizable footprint and supply chain content in China, we realized very early that potential disruption could occur as a result of Covid-19.

In response, we established regular, global executive calls beginning in late January. We continue to have these calls each business day. Internally, we are organized as a team of teams with an executive steering committee that sets priorities, policies and protocols and regional teams that drive actions in line with these policies and inform our executive steering committee each day of impacts locally.

As we work through the challenges presented by Covid-19, we remain committed to ensuring the safety and well-being of our team members as they strive to support the essential needs of our customers.

Our internal stated goal is for our facilities to be the safest place our team members can be when away from their homes. This has resulted in evolving policies and protocols as the virus has become more thoroughly understood.

As examples, we put in place international and domestic travel bans well ahead of getting government recommendations. We have mandatory temperature screening at all of our manufacturing sites globally. We provide face coverings at all our facilities globally. We implemented multiple procedural changes and reconfigured facilities in order to support social distancing.

We require that all employees who can work from home to do so. We also provide regular detailed communications and resources to our team members discussing issues relevant to Covid-19. I personally communicate to all employees on at least a weekly basis. Unfortunately to-date, we have had three employees globally test positive for Covid-19.

In response to each positive test, we immediately implemented a well-defined crisis management protocol. We notified employees and customers, as well as performed an orderly shutdown of the site within hours. This was followed by a thorough decontamination of the site by a third-party service provider in a multi-day shutdown prior to resuming operations.

Please advance to Slide 6. While Covid-19 has produced many challenges, it has also presented opportunities. Despite the uncertainty and lack of travel late in the quarter, our go to market teams secured a healthy $248 million of manufacturing wins in the fiscal second quarter. This result was dominated by our Healthcare/Life Sciences sector, which posted $102 million in manufacturing wins as we leveraged our expertise in supporting the needs of customers within these markets.

As of the time of this call, we have secured and are ramping five programs across the United States and Europe that are associated with ventilators or Covid-19 testing. The majority of these programs will be reflected in our fiscal third quarter wins. In addition, we are seeing upside from multiple customers for existing programs that support emergency medical applications.

Our teams’ ability to quickly adapt and persevere highlights our organization’s talent, strength and focus. We have a team that is truly committed to creating the products that build a better world.

Advancing to our guidance for the fiscal third quarter of 2020 on Slide 7. As we look forward to the fiscal third quarter, we expect to deliver revenue in the range of $790 million to $830 million. While markets are highly volatile, in aggregate our demand remains strong. Healthcare/Life Sciences demand and in particular critical care products is very robust.

Semiconductor capital equipment and defense demand also remain healthy. Aerospace is down considerably and on aggregate the balance of our Industrial and Communications business is mixed. Currently, all of our sites with the exception of Penang are allowed to operate at full capacity.

At our Penang facilities, by changing shift patterns, operating on a seven day per week schedule, focusing on productivity improvements and having non-production employees work from home, our output is now near full capacity.

Our operating margin in the fiscal third quarter will continue to be negatively impacted by challenges and inefficiencies resulting from Covid-19. As such, we are guiding operating margins in the 3.8% to 4.2%. We anticipate revenue and operating margins at these levels will lead to GAAP EPS in the range of $0.72 to $0.82 including $0.21 of stock-based compensation expense. We currently do not anticipate any non-recurring charges.

In providing this guidance, we have taken into consideration constraints on the global supply chain, workforce challenges, as well as potential operational inefficiencies that could occur due to Covid-19.

However, our guidance assumes no large-scale closures of our facilities, or those of our suppliers or customers due to Covid-19, nor does it assume that the COVID-19 outbreak will materially impact end-markets beyond what has already occurred.

We commit to providing timely and transparent updates should negative material changes to our revenue and EPS expectations occur within the quarter.

As we move forward, our team members remain our top priority. We continue to invest in our policies and protocols to operate in the safest manner possible. I want to thank our sites who have quickly adapted to meet the safety needs of our teams, as well as our team members who continue to be flexible, and patient as we implement change.

I am proud of the efforts of our entire organization, but particularly those in our manufacturing sites. It is through their courage and unwavering support that we are able to deliver lifesaving medical devices and other essential products to our customers and our communities.

I will now turn the call over to Steve for additional analysis of the performance of our market sectors and operations. Steve?

[Steven Frisch]

Thank you, Todd. Good morning. The COVID-19 pandemic impacted our fiscal second quarter operational metrics. To provide better context of the situation, I will start with the status of our global facilities on Slide 8. All of Plexus’ facilities have requirements placed upon them by the respective governments where they are located.

However, all of our facilities have been granted permission to conduct business. Our fiscal third quarter guidance includes the currently anticipated operational inefficiencies due to Covid-19. Our design centers, global headquarters and most office personnel are under mandates to work from home when possible.

Our teams have adjusted to this new paradigm and we believe we can function in this manner for an extended period of time if necessary. In regards to our manufacturing facilities, the status varies by region.

Starting in APAC, our China sites experienced a period of very limited production due to the restrictions imposed by their government in response to the spread of COVID-19. However, the team worked significant overtime and overcame supply constraints to fulfill most of our customers' orders within the fiscal second quarter.

For the fiscal third quarter, we anticipate full staffing levels and an improved local supply chain in China. As we announced on March 23rd, our sites in Malaysia are subject to the national movement control order. The current order restricts the number of employees who can work at our sites at 50%. The impact to some of our local suppliers is more severe as they were completely closed.

Our revenue softness for the fiscal second quarter can largely be attributed to the situation in Malaysia. As we start the fiscal third quarter, the order remains in effect, and we believe it could be extended past the current expiration date of April 28. However, as a result of mitigations we have put in place to protect the health of our employees Malaysian officials have eased some restrictions.

We have been allowed to create new shift patterns that continue the reduction of the number of employees in a facility, but they enable us achieve nearly full production rates. In addition, all of our critical Malaysian suppliers have been able to resume some level of production. We expect the situation in Malaysia to continue to improve throughout the fiscal third quarter.

Our sites in the Americas were largely unaffected by COVID-19 through the majority of the fiscal second quarter. That changed late in the quarter as we had one employee test positive for Covid-19 in our Boise site during the last week of the quarter. Our crisis management policies and procedures were initiated within minutes of learning of the issue.

The preparation by our EH&S, Corporate Communications and operations teams, as well as the execution of our Boise leadership team was exceptional, which enabled the site to reopen within a few days.

Our EMEA sites adjusted their policies and procedures early in the second quarter to ensure employee health and safety, as well. Fortunately, they do not have any incidents beyond the global supply chain issues associated with Covid-19 that all regions are managing.

Finally, and most importantly, we have made the commitment to our employees to make Plexus the safest outside of their homes. Todd highlighted some of the actions we are taking. I want to expand upon one of them, social distancing, in order to illustrate some of the steps we are taking to deliver on this commitment. Employees that can work from home are required to do so.

We have restricted access to buildings, to ensure compliance. We have modified shift patterns in our manufacturing facilities and reconfigured employee entrances for rent close contact situations. We have physically reconfigured workspaces to ensure proper separation and we have changed the layout of common spaces like lunch rooms and break areas to support proper social distancing.

As a leadership team, we start each business day reviewing our global approach to employee safety and to share best practices. We are making the transition from reacting to crisis to implementing a new operating rhythm. Our philosophy has been and will continue to be transparent communications with our employees, as well as our customers and shareholders as we adjust to this new environment.

Please advance to Slide 9 for a review of our performance by market sector. Three of our market sectors missed expectations in the fiscal second quarter, largely due to the negative impact that Covid-19 had on our operations.

Since we just review the events in each of our regions that impacted the fiscal second quarter, I will focus on the expectations for the sectors for the fiscal third quarter of 2020.

Our Healthcare/Life Sciences revenue is expect to decline over 20% in the fiscal third quarter. We have seen a 16% net increase in our fiscal third quarter forecast since the end of January. Significant demand increases with customers that provide products used for the testing, diagnosing, and treating of COVID-19 is driving the growth.

Given the urgent need for products we produce that fight Covid-19, we expect our Healthcare/Life Sciences demand to remain robust.

Our Industrial/Commercial sector is anticipating a high-single-digit decline for the fiscal third quarter. Strong demand from semiconductor capital equipment customers is being offset by weaknesses in the oil and gas, automated retail and transportation subsectors.

Some of the strengths in the semiconductor capital equipment subsector is market share gains due to our teams’ ability to deliver of the supply chain constraints.

Our Aerospace and Defense sector is forecasting a high-single-digit decline for the fiscal third quarter. We had been expecting sequential growth; however forecast declines in several commercial aerospace programs have changed that outlook. In regards to the rest of the sector, demand from our defense and space customers remains relatively stable, while demand from security customers is mixed.

Our Communications sector is expecting to grow almost 30% in the fiscal third quarter. Strong demand for Internet connectivity infrastructure products and the ramping of a new 5G wireless program are driving the growth. Some of the strength is due to the increased bandwidth requirements created by people staying at home, and working from home.

Please advance to Slide 10 for an overview of the wins performance of the fiscal second quarter. We won 36 new manufacturing programs that we expect to generate $248 million in annualized revenue when fully ramped into production.

The strong wins was a result of good momentum early in the quarter combined with diligence to close opportunities virtually. The team is adjusting to travel restrictions as they become a new variable in the sales process.

Finally, our trailing four quarters of wins of $844 million maintains our wins momentum above our goal at 26%.

Please advance to Slide 11 for further insight into the wins results by region. All regions benefited from the $248 million of total wins. The Americas region’s portion of the wins was a robust $85 million.

Included in the result is a product used in the fight against Covid-19 that we expect to have ramped within the fiscal third quarter. In addition, we anticipate two new program wins in the fiscal third quarter related to Covid-19. We are aggressively working to ramp – on ramp plans for those programs as well.

The APAC regions’ manufacturing wins of $101 million were the strongest they have been in over a year. The team did an outstanding job leading our customers through the adverse conditions of the fiscal second quarter.

As a result, they were rewarded with significant market share increases from two large customers in the semiconductor capital equipment industry, as well as from a key customer in the Communication sectors.

The EMEA region wins of $62 million were exceptionally strong. Included in the wins is a large life sciences program that our Darmstadt design center has been co-developing with the customer. This product will be produced in our Oradea, Romania facilities.

Please advance to Slide 12 for further insight into the manufacturing wins performance by market sector. Our Healthcare/Life Sciences team had an exceptionally strong wins results of $102 million in the fiscal second quarter.

Obviously we are energized by the program wins for the products that are used in the battle against Covid-19. However, we are also encouraged by the wins that will sustain the growth in the future quarters in addition to the large life sciences program for EMEA, the team added two meaningful imaging programs from a new customer for our China operations.

The Industrial/Commercial sector produced a healthy $60 million of manufacturing wins in the fiscal second quarter. This is the second straight quarter of wins growing over 30% and the sector’s strongest quarter in a year.

Market share gains with key customers is creating the wins momentum. The Aerospace and Defense sector generated $60 million of new wins in the fiscal second quarter, a large space program is the highlight for the quarter. Our demonstrated ability to produce high quality products for this demanding environment is enabling growth in this subsector.

Finally, our communications sector wins of $26 million, includes a meaningful new opportunity from an existing customer. The program expands our customers’ communication products into a new market within the transportation industry, our diverse industry knowledge is an example of how Plexus is providing value to our customers.

Please advance to Slide 13. We closed the fiscal second quarter with a strong form of qualified manufacturing opportunities totaling $2.4 billion. Our sector teams are doing an outstanding job of filling the funnel with new opportunities while simultaneously harvesting significant wins.

The Healthcare/Life Sciences funnel continues to be a healthy $1.3 billion. In addition to the normal business, the Covid-19 pandemic is creating new opportunities within the sector. Our teams are aggressively working with customers to qualify and quantify their needs, supporting our Healthcare/Life Sciences customers as the world battles the Covid-19 virus is a top priority for Plexus.

In spite of the robust win performance, Industrial/Commercial sector increased their funnel by over $50 million to close the fiscal second quarter at $455 million. The high-quality and exceptional delivery performance of our operation teams is creating the new opportunities.

The Aerospace and Defense sectors funnel at almost $500 million remains strong. In addition to the size the diverse mix of opportunities include significant defense and space programs.

A few final comments. There have been a lot of changes since the fiscal first quarter earnings call in January 23. As a review this morning, the challenges that the pandemic has brought are significant. I am proud, but not surprised to be able to say that the Plexus team is managing through each of them. The crisis will create more challenges, but it is also creating opportunities.

The commitment that the employees of Plexus have demonstrated is tremendous. They are solving the problems that Covid-19 traits and working to make a difference with the opportunities it brings.

I will now turn the call to Pat for an in-depth review of our financial performance. Pat?

[Patrick Jermain]

Thank you, Steve, and good morning, everyone. Our fiscal second quarter results are summarized on Slide 14.

Revenue of $767 million was sequentially down 10%, while gross margin of 8% was down 130 basis points. The lower gross margin was primarily due to the under absorption of fixed manufacturing expenses across all regions, seasonal compensation cost increases, and the incurrence of more than $4 million in Covid-19-related expenses.

Selling and administrative expense of $38.2 million was consistent with our expectations. As a percentage of revenue, SG&A was 5%, sequentially higher by 40 basis points due to the lower revenue and seasonal cost increases.

During the fiscal second quarter, we completed all restructuring activities related to the previously announced closure of our Boulder Design Center. These activities resulted in charges of approximately $6 million.

Before consideration of the restructuring charges, adjusted operating margin was 3%. Included in this quarter’s operating margin was approximately 75 basis points of stock-based compensation expense. Non-operating expenses of $3.1 million was better than expectations primarily due to foreign exchange gains.

GAAP diluted EPS of $0.43 included a charge of $0.18 per share related to the after-tax restructuring activities. Excluding this item, non-GAAP diluted EPS was $0.61.

Turning now to the balance sheet and cash flow on Slide 15. During the quarter, we purchased approximately 225,000 shares of our stock for $13.2 million at an average price of $58.57 per share. At the end of the fiscal second quarter, we had approximately $27 million remaining under the authorization.

However in March, we suspended the repurchase program indefinitely, given the current environment. For the fiscal second quarter, we used $29 million in cash for operations and spent $17 million on capital expenditures resulting in negative free cash flow of $46 million. Through the first six months of fiscal 2020, we generated free cash flow of $15 million

Despite the impact of Covid-19, we delivered a return on invested capital for the fiscal second quarter of 11.4%. This generated an economic return of 260 basis points above our weighted average cost of capital creating solid shareholder value. We believe Plexus is well positioned with a strong balance sheet as we face the future challenges presented by Covid-19.

As of April 4, 2020, cash totaled $227 million, while debt totaled $294 million. Our gross debt-to-EBITDA leverage ratio of 1.5 times compare to a covenant limit of 3.5 times. In addition to our strong balance sheet, we have significant funding available through our revolving credit facility should future needs arise.

Cash cycle at the end of the second quarter was 87 days, a sequential increase of 16 days. Please turn to Slide 16 for details on our cash cycle. Sequentially, inventory was higher by $30 million, while days increased by 12. The increase in days primarily related to the reduced revenue for the fiscal second quarter.

In addition, we procured inventory towards the end of the quarter as we prepared for higher revenue anticipated in the fiscal third quarter. Also in this environment, we are starting to experience longer lead times for certain components.

In order to meet greater demand for certain products and maintain a high level of customer service, we are procuring components earlier and accepting that inventory dollars will be higher.

Days and receivables were 55 days, sequentially higher by six days, the increase was primarily due to a reduction in receivables sold under our customer factoring program. In addition, the timing of shipments was weighted more towards the last month of the quarter compared to last quarter, which contributed to the increase in the days.

As Todd has already provided, the revenue and EPS guidance for the fiscal third quarter, I’ll review some additional details which are summarized on Slide 17.

Fiscal third quarter gross margin is expected to be in the range of 8.2% to 8.6%. At the midpoint of this guidance, gross margin would be approximately 40 basis points higher than the fiscal second quarter.

With an anticipated 6% sequential increase in revenue, we expect to experience better leverage of our fixed manufacturing expenses, as these expenses are forecasted to remain consistent quarter-over-quarter.

For the fiscal third quarter, we expect SG&A expense in the range of $35 million to $36 million. At the midpoint of our revenue guidance, anticipated SG&A would be 4.4% of revenue, sequentially improved by 60 basis points.

Impacted by inefficiencies of Covid-19, fiscal third quarter operating margin is expected to be in the range of 3.8% to 4.2%. This guidance includes 75 basis points of stock-based compensation expense.

A few other notes for the fiscal third quarter; depreciation and amortization expense is expected to be approximately $14 million consistent with fiscal second quarter. Non-operating expenses are expected to be in the range of $4.8 million to $5.2 million.

At the midpoint of this guidance, these expenses would be sequentially higher, primarily due to the absence of foreign exchange gains which were recorded during the fiscal second quarter.

For the fiscal third quarter, we estimate an effective tax rate of 15% to 17%, while we expect a non-GAAP effective tax rate of 12% to 14% for the full year. In addition, we are estimated diluted shares outstanding of approximately 30 million shares for the fiscal third quarter.

Our expectation for the balance sheet is for working capital dollars to remain relatively consistent. We expect higher inventory and accounts payable balances, as we increase procurement activity to meet the anticipated higher demand.

Based on our revenue forecast, we expect this level of working capital will result in cash cycle days of 82 days to 86 days. For the fiscal third quarter, we expect free cash flow around breakeven as we build inventory to support new program ramps. For the full year, we expect free cash flow in excess of $50 million.

Finally, our capital spending estimate for fiscal 2020 is expected to be in the range of $50 million to $60 million, slightly lower than our previous estimate.

With that Sidney, let’s now open the call for questions.

[Operator]

[Operator Instructions] Our first question comes from Adam Tindle with Raymond James. Your line is open.

[Adam Tindle, Raymond James]

Okay. Thanks and good morning. Todd, I just wanted to start, you mentioned that the guidance does not assume material impact to end-markets beyond what has occurred. So just to start, maybe can you touch on what has occurred thus far from a product order standpoint?

Because it seems like the shortfall in March is largely operational-related, which is understandable, but not a material reduction in demand thus far. So maybe just touch on what you’ve seen so far in demand reduction.

[Todd Kelsey, President and Chief Executive Officer]

Sure. So, from a demand standpoint, Adam, probably the biggest impact has been in our aerospace subsector. Now defense and space within that entire sector as we define it are strong. But aerospace itself is weak and we are also seeing much of Industrial/Commercial beyond semiconductor capital equipment as weak.

Now the semiconductor capital equipment demand is holding up rather well right now. I mean, I think there is some question out there in the market as to whether that’s going to be long-term or whether that’s a near-term situation. But right now it’s strong.

[Adam Tindle, Raymond James]

Okay. And if we follow kind of normal downturn, it typically takes another couple of orders or sharp order cuts, - quarters of sharp order cuts. Are those further downticks in order cuts contemplated in your guidance?

[Todd Kelsey, President and Chief Executive Officer]

For Q3, yes, yes. One other thing that’s worth noting too, Adam, is we talk about the strength in healthcare, and that’s a little bit bifurcated as well too. It’s very strong in critical care products and of course we won a number of new programs that are directly related to Covid-19.

But when you consider products that we make that are more used in, say, elective type, surgery type applications or things like that, the demands weaken quite a bit. So there is a bit of a mixture within healthcare as well, too.

[Adam Tindle, Raymond James]

Okay. And maybe just one final one for Pat. You created positive economic return despite navigating the pandemic. I know you’ve had some benefit from restructuring, but it’s still positive if we factor that in.

Maybe just first touch on how the team adjusted to achieve that and moving forward, margins are expected to move up, cash cycle down. So I would expect further improvement. If you could touch on the key drivers of the cash cycle improvement they are expecting to drive this? Thanks.

[Patrick Jermain]

Yes. So, at the end of the second quarter, we had the negative free cash flow and a lot of that was driven by not being able to factor some of our accounts receivable and I think we’ll see improvement in that area as we progress into the third quarter. Inventory levels will be more elevated in the third quarter as we ramp some of these new programs.

So I expect that, but also our payable days, I think that’s where we will see improvement and offset to the increase in inventory days. And we are securing some additional customer deposits, because in some of these markets that have upside demand where the customer wants to ensure inventory is on hand.

We are requesting customer deposits to help offset that working capital investment. So, I think the teams are doing a fantastic job around inventory management in all of our regions. And so, we are seeing improvements there. But in this near term, we will see some increases in inventory. Those are probably the main components for us of the cash cycle.

[Adam Tindle, Raymond James]

Makes sense. Thank you.

[Operator]

Thank you. And our next question comes from the line of Shawn Harrison with Loop Capital. Your line is open.

[Shawn Harrison, Loop Capital]

Hi, good morning everybody. It’s good to hear your voices. I wanted to delve into, I guess two topics. The first being just, the incremental outsourcing here and how much of it maybe is a pull-forward versus maybe a permanence of incremental outsourcing for a while that we’ve seen in prior market corrections?

[Steven Frisch]

Yes. So, I’ll take that one. This is Steve. I would say, the conversations with customers, and I'm going to expand your question a little bit, the conversations with customers is interesting right now, because a lot of customers are starting to look at what is from a continuity of supply strategy, what is COVID going to do for the long-term?

Today, it’s more reactionary, but I do expect that Covid-19 will change the manufacturing strategy for lots of customers and the ability, our teams’ ability to deliver through this crisis is definitely helping us gain market share with several customers. And as we look at the incremental part of that is, is it goes into the future quarters.

We would expect customers that if the downturn comes, or if there is a slowdown, we would expect the opportunity to increase for the number of outsourcing opportunities. And so, it’s a little early to see what the impacts of Covid-19 are going to be. But I think your question is kind of focused on it, is this going to follow a similar pattern? I guess our expectation is that it probably will.

[Shawn Harrison, Loop Capital]

Okay. And then, I guess, there is a follow-up, the strength in the communications business, is that kind of – is it level off here in the June quarter? Or is this something because of the work from home environment you see multiple quarters of incremental spend by the big broadband providers and other kind of Internet providers that we all need that signal at home?

[Steven Frisch]

Yes. At the beginning of Q2, our forecast for Q3 did show some strengthening. So, we did anticipate some strengthening. Covid-19 has increased that in a substantial way. We do expect it to stabilize at this level. The question will be is probably get into 2021, what does it look like and obviously it’s a bit early to call that one.

[Shawn Harrison, Loop Capital]

Okay. That’s great, Steve. Thank you.

[Operator]

Thank you. And our next question comes from the line of Jim Ricchiuti with Needham & Company. Your line is open.

[James Ricchiuti, Needham & Company]

Thank you. Good morning. I may have missed it. But could you provide any Covid-19-related expense that maybe embedded in your gross margin guidance for fiscal Q3?

[Todd Kelsey, President and Chief Executive Officer]

So, I’ll start with this and then I’ll pass it off to Pat a bit more specifics as we – as I think about Covid-19. One of the things with regards to our guidance, our demand is higher than our guidance. So we are staffed for higher demand.

But we are – so that’s impacting our margins. But we are realistic in knowing that there are significant challenges within the supply chain right now and the ability to be able to get the parts that we need and the time that we need. I mean, it’s more – certainly more volatile than would be in a normal environment. So we are taking that into account.

But beyond that, we’ve taken an approach that if we need to have an employee self-quarantine because of Covid-19 or if we choose to close a site for a period of time, as a result, we compensate our employees. So there is some direct cost around that as well as PP&Es. So, and I’ll pass it off to Pat and he can give you more specifics around the numbers.

[Patrick Jermain]

Sure. Yes. So, Jim, in Q2, we had the $4.7 million. In Q3, we are expecting that to be around $2 million and to Todd’s point, combination of direct equipment and some labor cost. And so, from a margin standpoint, we are guiding operating margin of 3.8% to 4.2%. So the midpoint is 4%. Those direct costs that we expect in Q3 are about 30 basis points.

So without those, you’d be at about 4.3%. So we are still below our target range of 4.7% to 5% and that’s where I think this difference is really in the inefficiencies that we’ll see in sites as some programs are coming down significantly and we are managing that labor force, while other programs are increasing and sites need additional headcount and managing through that labor situation.

So I think that kind of bridges where – how we get back to our target range in future quarters.

[James Ricchiuti, Needham & Company]

It’s helpful. If we look at the Aerospace and Defense segment, is there way for – can you size what the commercial aerospace represents of that, only because it doesn’t sound like that business is coming back anytime soon. Is that a fair way to think about it?

[Patrick Jermain]

Yes, it will be down for a while certainly, and that’s about half of our business within the sector.

[James Ricchiuti, Needham & Company]

Okay. And then, on the Healthcare/Life Science, I think it’s interesting the way – you are clearly seeing the benefit there from all of the increased demand as it relates to critical care. Do you have any sense as to when that more elective piece that you alluded to might start coming back or is that still a little tougher to tell given that we are still in the thick of things here?

[Steven Frisch]

Yes. So, this is Steve. I’ll try to answer that the best I can. If you breakdown Healthcare/Life Sciences and I talked about the fact that we had a net 16% increase from our January forecast for Q3 to our April forecast for Q3, if you look at healthcare, the healthcare portion was actually a 20% increase and life sciences was relatively flat.

If you look at the top 15 customers just within the healthcare subsector, all 15 had double-digit movement from January to April. However, nine of those were up and six were down. The six that were down were associated with non-critical healthcare products, elective procedures. And so, with – do we expect the double-digit continue to increase?

That will depend a bit on pandemic, but we do expect those elective procedures will return as the economies across the globe get turned back on and elective procedures start to happen. The question that we are asking is, is there going to be a pent-up demand?

Is it going to be a slower ramp, but we would expect those elective programs to come and that demand to come back as soon as the economies of world to turn back on and people are basically allowed to move.

[James Ricchiuti, Needham & Company]

That’s helpful, Steve. The last question for me is just on the Industrial/Commercial side of the business and this may be tough to call, but do you get the sense that June maybe the bottom? Or is this just the visibility maybe just too limited here?

[Steven Frisch]

I think the, again, looking at the changes that we’ve seen in the forecast from the January cycle to the April cycle, the forecast demands in some of those subsectors that we talked about coming down, I mean, it come down substantially.

And so, we do believe that a fair amount of the customers have taken a pretty good look at where their forecasts are going to be for our fiscal Q3. And so, they’ve adjusted pretty well. Is it going to come down more? I think that’s a little bit early for us to tell in terms of what’s going to happen given the global situation.

[James Ricchiuti, Needham & Company]

That’s fair enough. Thank you.

[Operator]

Thank you. And our next question comes from the line of Paul Coster – JPMorgan. Your line is open.

[Paul Coster, JPMorgan Chase & Co.]

Yes. Thanks for taking my questions. Just a quick pass-through on the healthcare front first of all. Are any of the – is any of this new business from new logos, is it brand new products that the customers have kind of devised on the fly or are they existing programs that they are ramping up?

As you ramp up, do the margins kind of – are they under pressure initially and then do they improve over the course of time?

[Todd Kelsey, President and Chief Executive Officer]

Yes, in general, Paul, the five new wins that I talked about are our new programs that are in the process of ramping. I think those are – the margins should be fine with those. I think we will be able to ramp those at kind of corporate level margins, though. So, I wouldn’t expect it to be dilutive during the ramp period.

[Paul Coster, JPMorgan Chase & Co.]

No new logos at this time?

[Todd Kelsey, President and Chief Executive Officer]

Yes, there are new logos.

[Paul Coster, JPMorgan Chase & Co.]

Included in that five?

[Todd Kelsey, President and Chief Executive Officer]

There are, yes, correct.

[Paul Coster, JPMorgan Chase & Co.]

Interesting. Okay. And then, just a quick question on credit risk. Are you seeing any issues amongst your customers that you are monitoring carefully?

[Todd Kelsey, President and Chief Executive Officer]

Well, we are monitoring credit really carefully. But we have not seen any concerns at this point. The benefit is, when you look at our customer list, our top-10 customers make up 55 or so percent of our revenue, all international companies. So we feel comfortable at this point, but it is something we are going to closely monitor.

[Paul Coster, JPMorgan Chase & Co.]

Your sales team is working remotely and virtually at the moment and I guess it’s reasonable to expect that their win rates probably got – now that they’ll lose business to anyone, but just the ability to close deals will be impaired somewhat in this next quarter. Is that a fair assumption? Should we have fairly – should we expect the manufacturing wins to be more modest in fiscal 3Q and then maybe pickup in the back-end of the calendar year?

[Steven Frisch]

I wouldn’t assume that just yet. I think, opportunities with new logos may be a little bit harder to close. However, we are seeing increased opportunities with existing customers and so, our expectation with the business development teams is that, they are going to continue to deliver with that.

Our corporate communications team is doing a fair amount of work with virtual videos and things to allow and give our sales force the tools that they need to be able to continue to sell our services. And so, again, I think, new logos maybe a little bit more challenged.

They may slowdown their decision-making. But we potentially see our existing customers providing more opportunities. So the split might shift a little bit.

[Paul Coster, JPMorgan Chase & Co.]

Got it. And then last question. Going back to Jim Ricchiuti’s question around the defense and Aerospace segment. So, I assume first of all the 50% that was commercial was on a backward-looking basis looking forward you mentioned it’s going to be a smaller percentage at least for a while to confirm that.

But also, can you just clarify for us, what kind of business you are doing in the commercial Aerospace segment? Is it newbuilds, i.e. new aircraft? Or is it related to actual air miles traveled and therefore, sort of a consumable product?

[Todd Kelsey, President and Chief Executive Officer]

Yes, it’s a combination of both, Paul. There is a – certainly it’s dominated by the newbuilds. But there is an amount of aftermarket business that we have and that’s obviously taken a near-term hit right now, the aftermarket business. And the 50:50 split I call that a pre-COVID split.

[Paul Coster, JPMorgan Chase & Co.]

Right. So, therefore if there is a recovery at air miles travels, we should at least see the variable, consumable aftermarket business pickup. I hate to be picky, but what percentage of the commercial Aerospace businesses is aftermarket versus newbuild or if you can guess of that?

[Steven Frisch]

Yes, unfortunately with our customers, we are shipping field units that we don’t always get visibility completely what’s going in the new aircrafts versus aftermarket services. It would be purely a guess for me.

[Paul Coster, JPMorgan Chase & Co.]

All right. Okay, thank you so much.

[Operator]

Thank you. And our next question comes from the line of Anja Soderstrom with Sidoti. Your line is open.

[Anja Soderstrom, Sidoti & Company]

Hi everyone. Thank you for taking my question.

[Todd Kelsey, President and Chief Executive Officer]

Hi, Anja.

[Anja Soderstrom, Sidoti & Company]

A lot of good questions asked already. So, I am just going to ask about the SG&A. You are sort of guiding down to - for the third quarter. Is that due to the seasonal compensation going down or are there other moving parts there and how sustainable is that for the coming quarters? How we should we think about that?

[Patrick Jermain]

Yes. So, it’s not the seasonal cost coming down, because those go into effect January 1st those are merit increases. So those are carrying through. Some of it is better inefficiencies that were driving better productivity. We are seeing some of the COVID expenses that flow through in Q2, be smaller in Q3.

And what we’ve done from a discretionary spending standpoint is really pulled that back. Travel, as you can imagine is essentially non-existent and some of our headcount hires we’ve delayed. So, Q3 is going to be much smaller and lower and as we go into Q4, I expect that to rebound a bit and probably be closer to $38 million in Q4.

Some of that is variable incentive compensation expense as well, that’s down in the third quarter. But we expect higher expense in the fourth quarter. So, I think going forward, something in the $38 million range per quarter is probably reasonable.

[Anja Soderstrom, Sidoti & Company]

Okay. Thank you. And then, it seems like your non-operating expenses are ticking up a bit too. What’s the moving parts there?

[Patrick Jermain]

Probably two main things there, Anja. One is, in Q2, we had about $1 million of foreign exchange gain and those were driven by mainly in Mexico the peso devaluation generated some gains for us. So that was about $1 million that we wouldn’t anticipate recurring in Q3.

Also with the increase in working capital that we started to experience towards the back half of the second quarter, we expect that to continue into the third quarter. So our borrowing is higher than the quarter and the interest expense is going to be higher than what we had in the second quarter.

So they are again, I think going forward and the – kind of the midpoint of that guidance for the third quarter is $5 million. That was pretty similar to what we had previously guided for prior quarters. So removing the FX activity, I think $5 million, $4.5 million to $5 million a quarter is a pretty reasonable number assuming no FX gains or losses.

[Anja Soderstrom, Sidoti & Company]

Okay. Thank you. And then in terms of inventory and supply chain, I understand that’s a bit challenging now. What do you see in the supply chain? How – do you expect that to be challenging going into next year? Or is it – does it going to improve? Or just a bit of a color what you are seeing there?

[Steven Frisch]

Yes, this is Steve. The supply constraints – the supply chain constraints we are seeing now are more associated with facility closures due to COVID-19. And so, our expectation is, as all facilities come back online, the supply chain constraints will free up and we’ve seen that happen with some of our suppliers particularly in Malaysia and China.

They had shutdown early and they’ve come back online and the supply chain constraints are starting to disappear. Now, obviously the pandemic is widespread and so, many different companies, both on the custom engineering components as well as electronics have seen different portions of their business get shutdown for periods of times.

And so, it’s sporadic, but it’s meaningful. And again, we’d expect that to return to more normal things as these facilities get back online and the world manages the pandemic.

[Anja Soderstrom, Sidoti & Company]

Okay. Thank you. And the shutdown is due to them not being deemed essential businesses or?

[Steven Frisch]

No, the facility shutdowns are – yes, similar to what we’ve faced in Malaysia. Although we are in essential businesses, different governments are – making the case early for us in the quarter. We are only allowed to have 40% of our workforce in the facility. And so, production for us was limited.

Now, some suppliers including some of ours were deemed not essential and they were forced to shut down completely. And so, we’ve been working with the respective governments to basically help them understand that supply chain is critical and we’ve been able to get some of those suppliers turn back on.

And I think if this trend continues, and we are seeing it continuing through the fiscal third quarter here, we’ll see these suppliers coming back online and reaching more normal levels of production which will basically free up some of these constraints.

[Anja Soderstrom, Sidoti & Company]

Okay. Thank you. That was all for me.

[Todd Kelsey, President and Chief Executive Officer]

Thank you.

[Operator]

Thank you. Our next question comes from Matt Sheerin with Stifel. Your line is open.

[Matthew Sheerin, Stifel, Nicolaus & Company]

Thanks and good morning. I appreciate all the color so far. Just only question for me just regarding the healthcare business in the ramps you are seeing in the Covid-19-related programs. Could you give us an idea of the sustainability of those programs in terms of lifecycles or any programs that are more one-off or two or three quarters in terms of getting equipment out there?

[Todd Kelsey, President and Chief Executive Officer]

Yes, I would say, Matt that, one or two of these, I would call one-off programs that probably have a one to three quarter duration to them and the remainder would be sustainable, but I would anticipate that that once we get out somewhere from two to four quarters, that their volumes would drop a bit.

[Matthew Sheerin, Stifel, Nicolaus & Company]

Okay. And I guess, in theory, at that point, you will see the elective equipment, surgery type of programs ramp to offset that.

[Todd Kelsey, President and Chief Executive Officer]

We believe so, yes.

[Matthew Sheerin, Stifel, Nicolaus & Company]

Okay. Okay. That’s it for me. Thanks so much.

[Todd Kelsey, President and Chief Executive Officer]

All right. Thanks, Matt.

[Operator]

Thank you. I am not showing any further questions at this time. I would now like to turn the call back to CEO, Todd Kelsey for any further remarks.

[Todd Kelsey, President and Chief Executive Officer]

All right. Thank you, Sidney. And again, I want to thank everyone who joined our call today. We certainly appreciate your support and interest in Plexus. These are certainly interesting times and I am sure it’s impacted all of you. Some of you are probably at a different location than you typically are as you are listening to this call.

But I know, I certainly look forward to the day when things are closer to normal and stay safe and stay healthy and we’ll talk to you soon.

[Operator]

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.