Don't Panic. From Barron's Weekday Trader:
FEBRUARY 24, 2000
Fallen Star Solectron May Shine Again
By Carolyn Whelan
Honesty may be the best policy, but it isn't always rewarded.
Take Solectron, one of the best-performing stocks of the 1990s, with an amazing compound annual return of 70% and a total return of more than 20,000% for the decade.
But last month, the number-one contract manufacturer of printed circuit boards tried to come clean with investors, and its stock got pummeled in the process.
In December, Solectron warned Wall Street that its second fiscal quarter would be seasonally slow. Throw in component shortages, overstocked inventories and some acquisitions, and investors ran for the exits. After a further 7% selloff Thursday, the stock is more than a third off its 52-week high of 98, set late last year.
But some call that overkill. Robust demand for mobile phones (whose revenues are growing fast), soon-to-close acquisitions and an insatiable appetite for outsourcing, they say, should keep Solectron's factories full -- and send its stock price higher again.
"The market overreacted," says James Savage, an analyst at Thomas Weisel Partners, who upgraded the stock to Strong Buy from Buy on February 2. It "has already fully discounted risks and is not seeing new opportunities."
"This whole outsourcing trend is powerful, and has a long way to go," adds David Harrington, portfolio manager of the Brandywine Fund.
In fact, revenues from EMS (electronic manufacturing services), or contract manufacturing, are expected to more than double to nearly $150 billion in 2003, up from $73.2 billion in 1999, according to Alameda, CA-based Technology Forecasters, a market research firm.
Contract manufacturing frees companies to focus on more "value-added" engineering and design tasks (see Weekday Trader, "Contract Firms Thrive as Tech Goes Fabless," September 2, 1999).
Because of the exploding demand for their services, contract manufacturers can max out their assembly lines with orders for, say, IBM notebooks or Ericsson handheld phones.
But that has a downside: Surging demand for cell phones far surpassed the most ambitious estimates, and Solectron got slammed by an unanticipated shortage of key parts, like flash memory chips. So, inventory of nearly-finished phones piled up on factory shelves, and sales suffered.
"Since Solectron does more cell phones than anyone else, they probably felt it more acutely," explains Shelby Fleck, an analyst at Morgan Stanley Dean Witter who rates the stock a Strong Buy.
But the bulls call it a short-term glitch from which the company should recover.
Shortages probably won't ease for a couple of quarters, they concede. But as the largest contract manufacturer in the world, Solectron should "be able to negotiate better allocation of existing capacity," says Fleck. And when handsets are finally assembled and shipped, revenues could get a nice boost.
Already, Solectron's mobile phone business has increased more than fifteenfold over the last two years, to $350 million in the first quarter of fiscal 2000, from $23 million in the same quarter of 1998. Last quarter, more than half of Solectron's sales came from data communications products and phones to customers like Cisco Systems and Lucent Technologies (which account for 10% of sales each), LM Ericsson and Nortel Networks.
That trend should continue: Shipments of mobile phones, which are increasingly being outsourced, are expected to grow nearly 90%, to 321 million in 2001, up from 171 million in 1998, according to San Jose, CA-based Dataquest, a unit of the Gartner Group.
Also, Solectron has announced several high-profile acquisitions from Ericsson and Alcatel, which should close on April 1. That may mean more business in the future.
"Certainly with Ericsson and Motorola there are some substantial wireless opportunities," says Savage.
Add those up, the bulls say, and the company should hit its sales targets this year.
"They'll meet numbers or come so close that it won't be an issue," says John McManus, an analyst at Needham & Company, who upgraded the stock to Strong Buy from Buy last week and has a price target of 105 on the stock, which traded late Thursday at 65 15/16.
Most importantly, say Solectron fans, it is the leader in a robust industry, with a top-notch track record and customer base.
"Their quality of earnings are high, and excellent for a company of their size," says McManus.
Finally, the stock actually looks reasonable, the bulls say.
"Typically Solectron trades at a premium," explains Fleck, but today it trades at a discount to its peers. Competitors Flextronics and Sanmina trade at around 63x forward earnings, or at a 50% premium to Solectron's P/E of 39x expected earnings of $1.69 a share for the fiscal year ending in August 2000.
"The stock is way undervalued," argues McManus.
Solectron is selling at a nice discount to its estimated fiscal 2000 earnings growth rate of 48%. It's also trading at 29x the $2.24 it's expected to earn in 2001, about in line with its projected earnings growth rates of 32% that year and 30% annually over the long term. That P/E is also below its historical average of 33x and the group average of 38x forward earnings. Perhaps that's why four firms recently upgraded their ratings, three of them to Strong Buy.
But Solectron, like its peers, faces risks, including those pesky component shortages and a slowing economy. Among other challenges are integrating acquisitions smoothly, says Fleck, and managing complex and geographically dispersed supply chains.
"But right now their biggest problem is satisfying demand," sums up McManus
That may be a short-term headache. But in the long run, it's the sort of "problem" most companies -- and investors -- would kill for.
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