Flextronics: EMS Up-an-Comer Stays Strong
The contract manufacturing industry, often called electronic manufacturing services (EMS),
has produced a number of stocks that are up tenfold in recent years. Just in the past few
months, though, a divergence has occurred among the top stocks in this business. A few of
the biggest EMS firms have seen their stocks falter -- Solectron, SCI Systems and Celestica
to name a few -- while some of the fast-rising stars like Flextronics (Nasdaq:FLEX - news)
remain at or near their highs. The question for investors is how will this divergence be
reconciled, if ever.
The EMS industry has been such a strong performer because of the massive outsourcing trend sweeping across most high-tech
industries. Original Equipment Manufacturers (OEMs) such as PC and networking equipment companies find it more efficient
and cost-effective to contract out the manufacturing of the electronic components, and in some cases the assembly and
distribution of the final products, to companies like Flextronics. This allows the OEMs to concentrate on product development,
marketing and sales, with an eye toward getting new products to market quickly and having the flexibility to respond to
changing markets more rapidly. Time to market is critical with the short product cycles of the high-tech world. Further, by
selling off manufacturing operations and outsourcing, OEMs can turn fixed costs into variable ones.
Electronics Manufacturing Services companies leverage their expertise and global production capacity to significantly lower
production and distribution costs. While manufacturing high-tech hardware and electronic components is a decidedly
unglamorous side of the tech world, investors like the business for its tremendous growth and earnings visibility.
A few years ago, the contract manufacturing industry was largely confined to assembling circuit boards for the original
equipment makers (OEMs), but now the OEMs are looking for help with product design, final systems assembly and testing.
Flextronics has been one of the most aggressive in responding to this demand by acquiring smaller companies with expertise in
these areas, making the company a "one-stop shop" solution. This not only adds business for Flextronics, but boosts the
otherwise slim margins commonly associated with electronics manufacturing.
Flextronics recently announced plans to buy design firm Palo Alto Products, known for designing the PalmPilot. In a much
larger deal announced last November, Flextronics announced a deal to acquire DII Group, another EMS firm with sales of
more than $1 billion. The DII acquisition adds significant production capacity and global distribution, not to mention new
customers. Flextronics had been a distant number four in terms of revenues among EMS companies, behind Solectron
(NYSE:SLR - news) , SCI Systems (NYSE:SCI - news) and Celestica (NYSE:CLS - news) , but this deal closes the gap
considerably.
The fact that Flextronics is growing so rapidly, both internally and through acquisition, may account in part for its stock
outperforming its peers in recent months. According to First Call, analysts predict earnings growth at FLEX to be 68% this
fiscal year and 30%-35% over the next five years. That outstrips most estimates for the overall industry growth rate of 25%,
suggesting Flextronics will continue to gain market share.
Shares of FLEX have soared from a split-adjusted $6.58 in August 1998 to $55.50 currently, which is fairly representative of
the EMS stocks in general. But while FLEX and some of the other smaller contract manufacturers -- Jabil Circuit (NYSE:JBL
- news) and Sanmina (Nasdaq:SANM - news) to name a few -- are within 10% of their highs, the three largest EMS stocks
are suddenly down 20% to 33% from their highs.
This divergence bears close monitoring. The selling in the larger stocks could foreshadow a similar fate for the rest of the group,
or it may just signal a shift by investors into the smaller, faster growing players. Regardless of investment flows, Flextronics has
proven itself to be strong on execution, and it is clearly parked in front of a powerful evolution in the technology sector.
Management has focused on winning higher-margin business and has actually turned down contracts that would tie up capacity
with lower-margin products. In other words, the company isn't just chasing revenues by expanding capacity; it is concentrating
on areas where return on investment is maximized. That's a good quality to find for investors.
- James Hale
The Online Investor
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