Worth magazine Desert Bloom
Desert Bloom
by Melissa Phipps October 2001, Worth Magazine
Contract manufacturers are positioning themselves for growth during the technology downturn
In 1996, Patrick Renda ditched a career producing television sports and joined money manager J.&W. Seligman. With no formal investment training, Renda was assigned coverage of a group that received scant Wall Street attention: contract manufacturers, companies that take on spillover assembly from technology equipment makers such as IBM and Hewlett-Packard. "There was a lot of misunderstanding about the potential there," he says, "and not a lot of respect." Since the burst of the technology bubble, however, the fortunes of marque hardware makers have waned, and outsourcing has emerged as one of the few dependable trends in the sector. "Contract manufacturers are an intelligent way to play technology," Renda says.
Today firms such as Flextronics, Sanmina, and Celestica offer an increasingly sophisticated lineup of services that help companies shorten product cycles, lower costs, and globalize production. Currently, less than 20 percent of the $650 billion electronics equipment market is outsourced; that figure could one day climb to 60 percent or more. For investors, that means it will become increasingly easy to gain exposure to a broad array of new technologies by owning a single stock.
There are near-term risks, however. Contract manufacturers derive about half of their revenue from battered telecom and datacom companies. The largest players — Sanmina, Flextronics, Celestica, and Solectron — are taking restructuring charges, bracing for customer bankruptcies, and laying off workers. Solectron has estimated restructuring charges of about $628 million for the three quarters ended in August. Through mid-August, Merrill Lynch's index of contract manufacturers was down 31 percent, versus the Nasdaq's 21 percent drop.
But contract manufacturers are managing the downturn better than their customers. Cisco and Nokia are both off about 55 percent, and Nortel is off 79 percent. "During the worst tech correction in history, many of these guys are still making a 10 percent return on invested capital," says Robertson Stephens analyst Keith Dunne.
If approved, recent mergers should help newly combined players broaden their client base. Sanmina announced it would pay $6 billion in stock and assumed debt for competitor SCI Systems, which would make it the industry's second-biggest participant and offer needed exposure to medical, industrial, and consumer electronics. Solectron plans to acquire C-MAC for $2.7 billion in part to access its rival's business in automotive electronics. The market could be worth $9 billion by 2004.
Brutal market conditions appear to be reinforcing the outsourcing trend. Business at troubled Lucent is down about 20 percent this year, but the telecom company recently awarded Celestica a five-year, $10 billion contract to become a leading supplier of switching and wireless networking products. Unless Lucent goes out of business, Celestica shouldn't get stuck with unsold products if demand continues to fall. That's because Celestica and its large peers have gained the leverage to refuse any inventory risk in their contracts. This year, Cisco and Nortel have taken inventory write-offs of $2.2 billion and $1 billion, respectively; the big contract manufacturers have much lower exposure.
Now these large contract manufacturers are expanding their reach by bringing suppliers in-house and offering design, distribution, and other services. Last year, Flextronics struck an unprecedented deal with Microsoft to manufacture and help design Xbox video game consoles. It reportedly will receive $300 for each unit — the same amount as the Xbox's expected retail price (Microsoft is taking a loss in the hope of selling more software). In January, Flextronics secured a deal worth $2 billion to $3 billion a year to take over Ericsson's entire cell phone manufacturing operations.
The trend toward vertical integration can boost profit margins, but it requires digesting a lot of acquisitions and divestitures quickly and efficiently. For example, Flextronics has acquired more than 35 operations in the past two years. That's a lot to integrate, and given the low margins in this business, there's little room to stumble.
Midsize player Jabil Circuit is a more straightforward investment. Jabil has taken on only a few divestitures and has no designs on becoming vertically integrated. Yet revenue growth since 1997 has outpaced the industry average of 43 percent. Jabil is smaller than the top-tier competition but large enough to compete on price; it also maintains one of the lowest net debt to capital ratios in the industry. Recently, Jabil struck a $4 billion outsourcing deal with telecom equipment maker Marconi.
Plexus, a small-cap player with less exposure to communications technology, may also be a smart alternative to the consolidating giants. With half its revenue coming from medical, industrial, and automotive contracts, Plexus has the widest array of customers in the industry. Unlike its bigger peers, the company doesn't compete in low-margin, high-volume production; instead, it manufactures high-margin specialty products such as ultrasound equipment. In the nine months ended in June, Plexus's revenue increased 60 percent over the same period last year, to $805.6 million, and its net income rose 21 percent to $34.7 million. This year through mid-August, its stock was up 8 percent, the industry's strongest performance.
With inventory levels high and end-market demand uncertain, shares of both large and small contract manufacturers could fall further in the near term. Analysts say Flextronics and Jabil are the most vulnerable given their valuations of more than 30 times estimated 2001 earnings. But investors won't want to risk getting left behind, Seligman's Patrick Renda says. If history is any guide, he's right. The best year ever for contract manufacturing stocks was 1992, when the sector grew 119 percent coming out of a recession. —Melissa Phipps
Broader Is Better: Customer Composition Of Top Contract Manufacturers Name Stock Price Countries/
Facilities Top 10 Cust.
Exposure Telecom
Exposure Other¹
Exposure
CELESTICA
(NYSE: CLS) $40.54 11/37 83% 33% 0%
FLEXTRONICS
(NASDAQ: FLEX) $23.42 27/171 60 54 17
JABIL CIRCUIT
(NYSE: JBL) $25.99 10/26 67.5 44 14
PLEXUS
(NASDAQ: PLXS) $33.41 4/21 50 40 50
SANMINA*
(NASDAQ: SANM) $20.31 12/67 54 77 9
SCI SYSTEMS*
(NYSE: SCI) $27.00 19/53 75 25 18
SOLECTRON**
(NYSE: SLR) $14.35 24/69 65 65 11
Stock data as of 8/16/01.
Sources: Robertson Stephens; Merrill Lynch.
¹Consumer, Medical, Industrial Electronics
*Does not reflect Sanmina's proposed acquisition of SCI Systems
**Does not reflect proposed acquisition of C-MAC.
worth.com |
