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MULTI FINELINE ELECTRONIX INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 8, 2014

This Quarterly Report on Form 10-Q ("Quarterly Report") contains forward-looking statements that involve a number of risks and uncertainties. These forward-looking statements include, but are not limited to, statements and predictions as to our expectations regarding our revenues, sales, sales growth, net income and losses, inventory levels, production build plans, restructuring and reorganization efforts and related charges, operating expenses, research and development expenses, earnings, operations, gross margins, including without limitation, our targeted gross margin range, achievement of margins within or outside of such range and factors that could affect gross margins, yields, anticipated cash needs and uses of cash, credit lines, including compliance with covenants and usage of such lines, capital requirements and capital expenditures, payment terms, expected tax rates, results of audits of us in China and the U.S., needs for additional financing, use of working capital, the benefits and risks of our China operations, anticipated growth strategies, ability to attract customers and diversify our customer base, our sources of net sales, anticipated trends and challenges in our business and the markets in which we operate, trends regarding the use of flex and assemblies in smartphones, tablets and other consumer electronic devices, the adequacy of our facilities, capability, capacity and equipment, the impact of economic and industry conditions on our customers and our business, current and upcoming programs and product mix and the learning curves associated with our programs, market opportunities, customer demand, our competitive position, labor issues in the jurisdictions in which we operate, the commercial success of our customers and their products, critical accounting policies and the impact of recent accounting pronouncements. Additional forward-looking statements include, but are not limited to, statements pertaining to other financial items, plans, strategies or objectives of management for future operations, our financial condition or prospects, and any other statement that is not historical fact, including any statement which is preceded by the word "may," "might," "will," "intend," "should," "could," "can," "would," "expect," "believe," "anticipate," "estimate," "predict," "aim," "potential," "plan," or similar words. For all of the foregoing forward-looking statements, we claim the protection of the Private Securities Litigation Reform Act of 1995. Actual events or results may differ materially from our expectations. Important factors that could cause actual results to differ materially from those stated or implied by our forward-looking statements include, but are not limited to, our ability to successfully restructure our business and reduce our costs, the impact of changes in demand for our products, our success with new and current customers, our ability to be competitive in terms of price, technology, capability and manufacturing, our ability to maintain or grow our market share, our ability to diversify our customer base, the success of our customers and their products in the marketplace, our effectiveness in managing manufacturing processes, inventory levels and costs and reorganizations of our operations, the degree to which we are able to utilize available manufacturing capacity, achieve expected yields and obtain expected gross margins, the impact of competition, the economy and technological advances, and the other risks set forth below under "Part II, Item 1A - Risk Factors." These forward-looking statements represent our judgment as of the date hereof. We disclaim any intent or obligation to update these forward-looking statements.

Overview

We are a global provider of high-quality, technologically advanced flexible printed circuits and value-added component assembly solutions to the electronics industry. We believe that we are one of a limited number of manufacturers that provide a seamless, integrated flexible printed circuit and assembly solution from design and application engineering and prototyping through high-volume fabrication, component assembly and testing. We currently target our solutions within the electronics market and, in particular, our solutions enable our customers to achieve a desired size, shape, weight or functionality of the device. Current examples of applications for our products include mobile phones, smartphones, tablets, personal computers, consumer products, wearables, portable bar code scanners, computer/data storage and medical devices. We provide our solutions to original equipment manufacturers ("OEMs") such as Apple, Inc. and to electronic manufacturing services ("EMS") providers such as Foxconn Electronics, Inc., Protek (Shanghai) Limited and Flextronics International Ltd. Our business model, and the way we approach the markets which we serve, is based on value added engineering and providing technology solutions to our customers facilitating the miniaturization of portable electronics. We currently rely on a core mobility end-market for nearly all of our revenue. We believe this dynamic market offers fewer, but larger, opportunities than other electronic markets do, and changes in market leadership can occur with little to no warning. Through early supplier involvement with customers, we look to assist in the development of new designs and processes for the manufacturing of their products and, through value added component assembly of components on flex, we seek to provide a higher level of product within their supply chain structure. Our ability to add to our customer base may have a direct impact on the relative percentage of each customer's revenue to total revenues during any reporting period.

We typically have numerous programs in production at any particular time, the life cycle for which is typically around one year. The programs' prices are subject to intense negotiation and are determined on a program by program basis, dependent on a wide variety of factors, including without limitation, competitor pricing, expected volumes, assumed yields, material costs, and the amount of third party components within the program. Our profitability is dependent upon the extent of competitive pricing pressures, how we perform against our targets and the assumptions on which we base our prices for each particular program. Our volumes, margins and yields also vary from program to program and, given various factors and assumptions on which we base our prices, are not necessarily indicative of our profitability. In fact, some lower-priced programs have higher margins while other higher-priced programs have lower margins. Given that the programs in production vary from period to period and the pricing and margins between programs vary widely, volumes, while important for overhead absorption, are not necessarily indicative of our performance. For example, we could

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experience an increase in volumes for a particular program during a particular period, but depending on that program's margins and yields and the other programs in production during that period, those higher volumes may or may not result in an increase in overall profitability. In the mobility market, the first few months of production are the most critical in terms of growth and profitability opportunities.

Critical Accounting Policies

Information with respect to our critical accounting policies which we believe have the most significant effect on our reported results and require subjective or complex judgments of management are contained on page 32 in "Management's Discussion and Analysis of Financial Condition and Results of Operations" of our Annual Report on Form 10-K for the fiscal year ended September 30, 2013.

Comparison of the Three Months Ended June 30, 2014 and 2013

The following table sets forth our Statement of Operations data expressed as a percentage of net sales for the periods indicated:

Three Months Ended June 30, 2014 2013 Net sales 100.0 % 100.0 % Cost of sales 105.5 103.1 Gross loss (5.5 ) (3.1 ) Operating expenses Research and development 1.3 1.5 Sales and marketing 3.5 4.2 General and administrative 3.2 1.9 Stock-based compensation resulting from change in control - 7.0 Impairment and restructuring 6.4 5.5 Total operating expenses 14.4 20.1 Operating loss (19.9 ) (23.2 ) Other income and expense: Interest income 0.1 0.2 Interest expense - (0.1 ) Other (expense) income, net 0.5 0.1 Loss before income taxes (19.3 ) (23.0 ) Provision for income taxes (2.8 ) (0.0) Net loss (22.1 ) % (23.0 ) %



Overview. During the three months ended March 31, 2014, we initiated a restructuring plan to substantially reduce costs and return to profitability. The restructuring plan includes consolidation of our production facilities to reduce the total manufacturing floor space by approximately one-third. Our facility in Chengdu, China, along with two satellite manufacturing facilities in Suzhou, China, will be consolidated into our two main manufacturing plants under MFC in Suzhou. In addition, we expect to close our facility located in Cambridge, United Kingdom and realign headcount at other locations. In connection with these restructuring actions, we anticipate annual cost savings of approximately $50.0 million, of which approximately 90 percent is expected to reduce cost of sales and approximately 10 percent is expected to lower operating expenses.

During the three months ended June 30, 2014, additional expenses were incurred as we continued to execute our plan of reducing square footage, reducing headcount and implementing other cost saving activities. These additional costs impacted our cost of sales and impairment and restructuring in our Condensed Consolidated Statements of Comprehensive Income . In addition, the activity of relocating production lines caused disruptions in manufacturing flows which lowered efficiencies and depressed margins. By the end of our third quarter of fiscal 2014, the restructuring activities were substantially complete.

Net Sales. Net sales decreased to $130.8 million for the three months ended June 30, 2014, from $136.1 million for the three months ended June 30, 2013. The decrease of $5.3 million, or 3.9%, was primarily due to decreased net sales into our smartphones and consumer electronics sectors, partially offset by increased sales into our tablets sector, as further quantified below. Net sales to our largest customer decreased $23.4 million to $56.7 million for the three months ended June 30, 2014, primarily the result of lower production volumes of certain products and lower share of business in certain programs.

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Net sales to our newer customers increased $43.1 million, or 214.4%, to $63.2 million for the three months ended June 30, 2014, from $20.1 million for the three months ended June 30, 2013. For the three months ended June 30, 2014, one of our newer customers accounted for approximately 23% of our total net sales.

Net sales into our smartphones sector decreased to $84.9 million for the three months ended June 30, 2014, from $105.5 million for the three months ended June 30, 2013. The decrease of $20.6 million, or 19.5%, was primarily due to decreased sales volumes to a major customer in this sector of approximately $30.8 million to near zero as a result of its significant reduction in market share, coupled with a decrease to our largest customer of approximately $18.0 million, partially offset by increased sales volumes to a few of our newer customers in this sector of approximately $24.3 million. For the three months ended June 30, 2014 and 2013, our smartphones sector accounted for approximately 65% and 78% of total net sales, respectively.

Net sales into our consumer electronics sector decreased to $8.5 million for the three months ended June 30, 2014, from $10.9 million for the three months ended June 30, 2013. The decrease of $2.4 million was primarily due to decreased sales volumes to our largest customer in this sector of approximately $3.7 million, partially offset by increased sales volumes to one of our newer customers of approximately $1.0 million. Net sales into our consumer electronics sector accounted for approximately 6% and 8% of total net sales for the three months ended June 30, 2014 and 2013, respectively.

Net sales into our tablets sector increased to $22.0 million for the three months ended June 30, 2014, from $17.1 million for the three months ended June 30, 2013. The increase of $4.9 million in net sales into the tablets sector was due primarily to increased sales volumes to a newer customer in this sector of approximately $7.6 million, partially offset by decreased sales volumes to our largest customer of approximately $1.7 million. For the three months ended June 30, 2014 and 2013, our tablets sector accounted for approximately 17% and 13% of total net sales, respectively.

Gross Margin. Cost of sales as a percentage of net sales increased to 105.5% for the three months ended June 30, 2014 versus 103.1% for the three months ended June 30, 2013. The increase in cost of sales as a percentage of net sales was attributable to additional costs associated with restructuring efforts to consolidate production lines into fewer facilities and lower overhead absorption due to excess production capacity. These additional costs included labor, supplies and parts necessary to start up relocated lines and lower direct labor efficiencies for production during the period in which lines were being moved. Gross loss was $7.2 million for the three months ended June 30, 2014 as compared to gross loss of $4.2 million for the three months ended June 30, 2013. As a percentage of net sales, gross margin decreased to (5.5%) for the three months ended June 30, 2014 from (3.1%) for the three months ended June 30, 2013.

Research and Development. Research and development expense decreased by $0.3 million to $1.7 million for the three months ended June 30, 2014, from $2.0 million for the three months ended June 30, 2013. The decrease is primarily related to continued reduced variable spending. As a percentage of net sales, research and development expense decreased to 1.3% from 1.5% in the comparable period of the prior year.

Sales and Marketing. Sales and marketing expense decreased by $1.2 million to $4.5 million for the three months ended June 30, 2014, from $5.7 million in the comparable period of the prior year. The decrease is primarily the result of reduced commissions resulting from reduced net sales as well as reduced variable spending. As a percentage of net sales, sales and marketing expense decreased to 3.5% from 4.2% in the comparable period of the prior year.

General and Administrative. General and administrative expense increased by $1.6 million to $4.2 million for the three months ended June 30, 2014, from $2.6 million in the comparable period of the prior year. During our third quarter of fiscal 2013, we had a gain of $1.5 million related to the disposal of certain fixed assets, which reduced our general and administrative expenses for that period. As a percentage of net sales, general and administrative expense increased to 3.2% from 1.9% in the comparable period of the prior year.

Stock-based compensation expense resulting from change in control. Stock-based compensation expense resulting from change in control was $0 and $9.6 million for the three months ended June 30, 2014 and 2013, respectively. This expense is related to the accelerated vesting of outstanding serviced-based restricted stock units ("RSUs") and stock appreciation rights, as well as the conversion of performance-based RSUs to service-based RSUs for awards outstanding as of May 23, 2013 as part of our change in control that was deemed to have occurred in connection with United Engineers Limited's acquisition of WBL Corporation Limited as of such date.

Impairment and Restructuring. During the three months ended June 30, 2014, we recorded impairment and restructuring of $8.4 million, which consisted of $6.9 million of asset impairments relating to our held-for-sale properties and equipment in Chengdu and Suzhou, China, $1.0 million of one-time termination benefits charges and $0.5 million of other restructuring-related costs. During the three months ended June 30, 2013, we recorded a goodwill impairment charge of $7.5 million.

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Other Income (Expense), Net. Other income, net increased to $0.7 million for the three months ended June 30, 2014, from other income, net of $0.1 million for the three months ended June 30, 2013. This increase was primarily the result of foreign exchange due to the movement of the U.S. dollar versus the RMB and other foreign currencies.

Income Taxes. The effective tax rate for three months ended June 30, 2014 and 2013 was (14.4)% and (0.2)%, respectively. The change in our effective tax rate was primarily due to additional tax provision recorded for certain uncertain tax positions, as well as our income and tax expense distribution by region. We expect future tax rates to vary if current tax regulations change.

Comparison of the Nine Months Ended June 30, 2014 and 2013

The following table sets forth our Statement of Operations data expressed as a percentage of net sales for the periods indicated:

Nine Months Ended June 30, 2014 2013 Net sales 100.0 % 100.0 % Cost of sales 103.8 99.2 Gross (loss) profit (3.8 ) 0.8 Operating expenses Research and development 1.0 1.0 Sales and marketing 3.2 2.8 General and administrative 2.4 2.1 Stock-based compensation resulting from change in control - 1.6 Impairment and restructuring 7.2 1.3 Total operating expenses 13.8 8.8 Operating loss (17.6 ) (8.0 ) Other income and expense: Interest income 0.1 0.1 Interest expense (0.1 ) (0.1 ) Other (expense) income, net 0.2 - Loss before taxes (17.4 ) (8.0 ) (Provision for) benefit from income taxes (2.3 ) - Net loss (19.7 ) % (8.0 ) %



Net Sales. Net sales decreased to $460.3 million for the nine months ended June 30, 2014, from $599.4 million for the nine months ended June 30, 2013. The decrease of $139.1 million, or 23.2%, was primarily due to decreased net sales into our smartphones, tablets and consumer electronics sectors, as further quantified below. Net sales to our largest customer decreased $199.4 million to $257.0 million for the nine months ended June 30, 2014 as a result of lower production volumes and lower share of business in certain programs. Net sales to this customer accounted for approximately 56% of our total net sales. Net sales to our newer customers increased to $164.5 million for the nine months ended June 30, 2014, from $58.4 million for the nine months ended June 30, 2013.

Net sales into our smartphones sector decreased to $328.4 million for the nine months ended June 30, 2014, from $415.8 million for the nine months ended June 30, 2013. The decrease of $87.4 million, or 21.0%, was primarily due to decreased sales volumes to one major customer in this sector of approximately $71.0 million to near zero as a result of its significant reduction in market share and a decrease to our largest customer in this sector of approximately $126.0 million, partially offset by increased sales volumes to another major customer of approximately $19.1 million and to two of our newer customers of approximately $83.2 million. For the nine months ended June 30, 2014 and 2013, our smartphones sector accounted for approximately 71% and 69% of total net sales, respectively.

Net sales into our tablets sector decreased to $71.0 million for the nine months ended June 30, 2014, from $136.8 million for the nine months ended June 30, 2013. The decrease of $65.8 million in net sales into our tablets sector was due primarily to decreased sales volumes to our largest customer in this sector of approximately $57.0 million, coupled with decreased sales volumes to a newer customer in this sector of $16.7 million as a result of certain programs reaching their conclusion during our second fiscal quarter of 2014. These decreases were partially offset by increased sales volumes to one of our newer customers of approximately $8.8 million as a result of new program ramps. For the nine months ended June 30, 2014 and 2013, the tablets sector accounted for approximately 15% and 23% of total net sales, respectively.

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Net sales into our consumer electronics sector decreased to $34.0 million for the nine months ended June 30, 2014, from $40.3 million for the nine months ended June 30, 2013. The decrease in net sales into our consumer electronics sector of $6.3 million was primarily due to decreased sales volumes to our largest customer of approximately $16.4 million, partially offset by an increase in sales volumes for one of our newer customers of approximately $10.3 million. Shipments into our consumer electronics sector accounted for approximately 7% and 7% of total net sales for the nine months ended June 30, 2014 and 2013, respectively.

Gross Margin. Cost of sales as a percentage of net sales increased to 103.8% for the nine months ended June 30, 2014 from 99.2% for the nine months ended June 30, 2013. The increase in cost of sales was primarily attributable to lower overhead absorption due to reduced production levels. Gross loss was $17.7 million for the nine months ended June 30, 2014, versus gross profit of $4.9 million for the nine months ended June 30, 2013. As a percentage of net sales, gross margin decreased to (3.8)% for the nine months ended June 30, 2014 from 0.8% for the nine months ended June 30, 2013.

Research and Development. Research and development expense decreased by $1.1 million to $4.7 million for the nine months ended June 30, 2014, from $5.8 million for the nine months ended June 30, 2013. The decrease of 19.0% was primarily due to continued reduced variable spending. As a percentage of net sales, research and development expense remained consistent at 1.0% for the nine months ended June 30, 2014 and 2013.

Sales and Marketing. Sales and marketing expense decreased by $2.1 million to $14.8 million for the nine months ended June 30, 2014, from $16.9 million in the comparable period of the prior year, which is a decrease of 12.4%. The decrease is primarily the result of lower negotiated commission rates and lower net sales volumes in the comparable periods. As a percentage of net sales, sales and marketing expense increased to 3.2% from 2.8% in the comparable period of the prior year.

General and Administrative. General and administrative expense decreased by $1.5 million to $11.1 million for the nine months ended June 30, 2014 from $12.6 million in the comparable period of the prior year, which is a decrease of 11.9%. This decrease was primarily due to our continued efforts to reduce variable spending, partially offset by a $1.6 million gain on disposal of equipment recorded during the nine months ended June 30, 2013. As a percentage of net sales, general and administrative expense increased to 2.4% from 2.1% in the comparable period of the prior year.

Stock-based compensation expense resulting from change in control. Stock-based compensation expense resulting from change in control was $0 and $9.6 million for the nine months ended June 30, 2014 and 2013, respectively. This expense is related to the accelerated vesting of outstanding serviced-based RSUs and stock appreciation rights, as well as the conversion of performance-based RSUs to service-based RSUs for awards outstanding as of May 23, 2013 as part of our change in control that was deemed to have occurred in connection with United Engineers Limited's acquisition of WBL Corporation Limited as of such date.

Impairment and Restructuring. During the nine months ended June 30, 2014, we recorded impairment and restructuring charges of $33.2 million, primarily to consolidate our manufacturing operations and to improve our cost structure. The $33.2 million consisted of $18.4 million of asset impairments relating to our held-for-sale properties and equipment in Chengdu and Suzhou, China, $9.6 million of one-time termination benefits and $5.1 million of other restructuring-related costs. During the nine months ended June 30, 2013, we recorded a goodwill impairment charge of $7.5 million.

Other Income (Expense), Net. Other income, net increased to $1.1 million for the nine months ended June 30, 2014, from $0.2 million for the nine months ended June 30, 2013. This increase was primarily due to foreign exchange due to the movement of the U.S. dollar versus the RMB and other foreign currencies.

Income Taxes. The effective tax rate for nine months ended June 30, 2014 and 2013 was (13.0)% and 0.5%, respectively. The change in our effective tax rate was primarily due to additional tax provision recorded for certain uncertain tax positions, as well as our income and tax expense distribution by region. We expect future tax rates to vary if current tax regulations change.

Guidance

Net Sales. For our fourth quarter of fiscal 2014, we expect net sales to range between $150 and $180 million.

Gross Margin. For our fourth quarter of fiscal 2014, we expect gross margin to be between 4% and 7%.

Operating Expenses. We expect normal operating expenses to be approximately $10 million or less during our fourth quarter of fiscal 2014.

Impairment and Restructuring. We expect our charges in connection with our restructuring plan incurred in our fourth quarter of fiscal 2014 to be minimal. Total charges in connection with the restructuring, including additional tax expenses related to the

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restructuring, are expected to be at or just below the low end of the range of $40 million to $60 million previously disclosed. As a result of the aforementioned cost savings, we expect to be profitable for the second half of the 2014 calendar year and to realize the majority of the anticipated $50 million of cost savings starting in our fiscal fourth quarter of 2014.

Income Taxes. We expect the effective tax rate (excluding restructuring), on average, to be in the mid to high teens for the coming year.

Capital Expenditures. For our fourth quarter of fiscal 2014, we anticipate capital expenditures to be between $5 and $8 million.

These projections are based on several business assumptions and are therefore subject to substantial uncertainty. See Item 1A of Part II, "Risk Factors."

Liquidity and Capital Resources

Our principal sources of liquidity have been cash provided by operations. Our principal uses of cash have been to finance working capital, stock repurchases and capital expenditures. We anticipate these uses will continue to be our principal uses of cash in the future.

It is our policy to carefully monitor the state of our business, cash requirements and capital structure. We believe that funds generated from our operations will be sufficient to fund current business operations over at least the next twelve months, without the need to repatriate earnings.

Changes in the principal components of operating cash flows during the nine months ended June 30, 2014 were as follows:

- Our net accounts receivable balance decreased to $94.4 million as of June 30, 2014 from $132.2 million as of September 30, 2013, which is a decrease of 28.6%, due to lower sales. Days sales outstanding on a quarterly basis increased to 65 days at June 30, 2014 from 63 days at September 30, 2013. Our inventory balance decreased to $43.4 million as of June 30, 2014 from $86.9 million as of September 30, 2013, which is a decrease of 50.1%. Days in inventory on a quarterly basis decreased to 28 days at June 30, 2014 from 40 days at September 30, 2013. Our accounts payable balance decreased to $99.6 million as of June 30, 2014 from $166.5 million as of September 30, 2013, which is a decrease of 40.2%, due to the expected lower production volume in our fourth quarter of fiscal 2014 versus our first quarter of fiscal 2014. Days payable on a quarterly basis decreased to 65 days at June 30, 2014 from 77 days at September 30, 2013. - Depreciation and amortization expense was $39.3 million for the nine month ended June 30, 2014, versus $44.0 million for the comparable period of the prior year, primarily due to decreased capital expenditures and disposals of certain property, plant and equipment during fiscal 2014. .



Our principal investing and financing activities during the nine months ended June 30, 2014 were as follows:

- Net cash used in investing activities was $7.0 million for the nine months ended June 30, 2014 and consisted of cash purchases of capital equipment and other assets of $14.0 million and cash restricted due to customs deposit requirement of $0.5 million, partially offset by proceeds of $3.4 million from sale of equipment and assets held for sale and a receipt of a $4.2 million cash grant from the local government in Chengdu, China, related to our capital investment in our Chengdu facility in calendar year 2011 and 2013. - Net cash provided by financing activities was $20.8 million for the nine months ended June 30, 2014 and consisted primarily of borrowings under our line of credit agreement with Agricultural Bank of China of $20.0 million and proceeds from exercise of stock options of $0.8 million. Our borrowings outstanding against credit facilities were $20.0 million and zero at June 30, 2014 and September 30, 2013, respectively. 22



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