Stock of the Day
Mar 10, 1999
Flextronics: Riding the Outsourcing Wave
Like other companies in electronic manufacturing services, Flextronics has seen its stock price level off this year after a stunning performance in the fourth quarter of 1998. Recent concerns about a slowdown in PC sales may be a contributing factor, and a warning about
disappointing results from industry leader SCI Systems last month might have caused investors to get a little nervous as well. But the core markets served by Flextronics, namely telecom/networking and consumer electronics, still appear quite healthy. Is this a case of throwing the baby out with the bath water?
Flextronics (Nasdaq:FLEX - news) is hardly a beaten-down stock. Upgrades from two brokerage firms helped Flextronics gain nearly six points on Monday, and at $38 currently, the stock has doubled in the past year and more than tripled from its $11 low last September. Year-to-date, though, the stock is down about 11% while the NASDAQ is up 9%.
Flextronics is very diversified in terms of the industries it serves. Consumer electronics accounted for 29% of revenues (FY99 third quarter), while telecom equipment represented 27% and networking added 19%. Computers were just 13% of revenues. So even if recent worries about a slowdown in PC sales turn out to be justified, Flextronics has several more powerful engines to sustain its growth.
The company has certainly delivered impressive growth over the years, going from $80 million in sales in FY92 to $1.6 billion currently. Over the past five years, Flextronics has achieved cumulative average growth rates of 62% in revenues and 47% in earnings per share. 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.
The accelerating trend toward outsourcing seems to be easily compensating for any negative issues facing the tech sector such
as slowing growth in PC sales or the ongoing weakness in Asia. In fact, some contract manufacturers are picking up business as a direct result of the Asian crisis. That's because many technology companies are cutting costs to offset the lost revenues from Asia, or at least reduce their risk when demand slows, and one way is to sell off manufacturing capacity and outsource production. That way a company is only paying for the production it needs, turning fixed costs into variable ones.
The market for outsourced electronics manufacturing continues to grow at an estimated 25% pace. This outsourcing has been a pervasive trend for high-tech companies in recent years. Many new tech firms simply develop technologies and hire someone else to do the manufacturing, but even well-established companies are selling their factories and embracing the idea of hiring specialists like Flextronics to produce certain components, or in some cases an entire system. Ericsson (Nasdaq:ERICY - news) , Philips, Cisco Systems (Nasdaq:CSCO - news) and Microsoft (Nasdaq:MSFT - news) are among its largest
customers.
The merits of outsourcing production are fairly obvious--specialized contractors can do it cheaper, faster, in higher volume, and often with higher quality. It lets high-tech companies concentrate on design, marketing & distribution with an eye toward getting new products to market quickly and having the flexibility to respond to changing markets more rapidly. The short product cycles of the high-tech world mean individual companies would be left in the dust unless they continually invested huge sums into manufacturing processes. Contract manufacturers have made the capital investment and can spread the cost over all its accounts, so even the big established companies that already have factories find it is cheaper to contract out. Flextronics has also established substantial production capacity around the globe, lowering distribution costs for companies that otherwise might have to build products in one or two plants and ship them all over the world.
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 responded 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 contract manufacturing.
So while contract manufacturing is not exactly a sexy high-margin business, it is in front of a powerful evolution in the technology sector. Analysts project a 39% increase in Solectron's earnings per share for the current year and a 28% growth rate over the next five years. Growth is certainly an important reason why analysts like this stock so much, but they also appreciate the earnings visibility created by Flextronic's long-term contracts.
Among electronics contract manufacturers, Flextronics is a distant fourth in terms of revenues. With $1.6 billion in sales, it is much smaller than SCI (NYSE:SCI - news) at $6.6 billion and Solectron (NYSE:SLR - news) at $6.1 billion. But its focus on fast growing, higher-margin areas like telecom/networking and medical electronics make it an attractive player in this market.
The Singapore-based company also boasts a low effective tax rate, just 12% in the nine months ended 12/31/98. Flextronics is structured as a holding company with subsidiaries subject to taxation in their respective countries. Many operations are located where tax rates are relatively low, and its Asian and Hungarian subsidiaries have been granted additional tax relief. The tax situation adds to cash flow, which is especially valuable in a capital-intensive business like this and could allow for above-average growth if Flextronics continues to invest wisely in its expansion.
Source: The Motley Fool 3/10/99 |
