People may have seen this article from SmartMoney on Yahoo, but I wanted to post it here "for the record". Nice overview, which I would post on the ECM thread if anyone ever posted there.
Best wishes,
Sam
SmartMoney.com - Sector Patrol
The Grease Monkeys of Technology
By Roben Farzad
Wednesday December 26, 9:24 am Eastern Time
JABIL (NYSE:JBL - news). CELESTICA (NYSE:CLS - news). Solectron
(NYSE:SLR - news). Flextronics (NASDAQ:FLEX - news). Sanmina
(NASDAQ:SANM - news) Quick: What do these guys do? To most of us, they're a
collection of unusually gobbledygooky names. But informed investors would tell you
that this is a roster of the leading companies in one of the most vital, but
underappreciated, subsectors in all of technology — electronic manufacturing services (EMS). Jabil, for example, makes
router parts for Cisco Systems (NASDAQ:CSCO - news). Celestica does heavy lifting for EMC (NYSE:EMC - news)
and Sun Microsystems (NASDAQ:SUNW - news). An obscure industry, perhaps, but a nice one. With hardware
outsourcing a $60 billion industry, there can be no doubting that it pays to be a technology manufacturing chore boy.
And in the three months since the market's
September low, the EMS gang (also known as
contract manufacturers) has been on a tear, with these
big players advancing 70% on average. Investors are
wagering that a tech spending rebound — which
would shower contract manufacturers with
production orders — is in the pipeline for the near
future.
Well, maybe. Unfortunately, this optimism comes
against a backdrop of a nasty manufacturing
recession brought on by stubbornly high inventory
levels. Raymond James's fourth-quarter survey of
information-technology demand sees contract
manufacturers sitting on 68 days' worth of
inventories, which is an improvement from last
quarter's 73 days but still uncomfortably above the
group's normal 45-day supply. That's a lot of excess
to burn off. Moreover, December sales in this
business are expected to decline 1% year-over-year
— worlds apart from December 2000's sequential
surge of 19%.
But even with valuations looking rich, that's not to say that the entire sector has gotten hopelessly ahead of itself. Rather,
you may still be able to play the EMS rebound if you pick wisely and carefully.
The necessity of good stock picking here became painfully apparent on Tuesday, when the industry's largest player
blotted its copy book. Solectron announced that it had lost $52.5 million, or eight cents a share, on sales of $3.15 billion
in its fiscal first quarter (ended Nov. 30). That's down from earnings of $190.6 million, or 29 cents a share, on sales of
$5.70 billion a year ago. Woeful as they were, those results were in line with Wall Street's expectations. The nasty
surprise came when Solectron predicted at best a break-even second quarter instead of the seven-cent profit analysts had
been hoping for. Shares plunged 18% to $12.10.
``Solectron is behind the EMS curve,'' says Kevin Denney, who follows contract manufacturers for merchant bank
Brean Murray. ``I would say it's confused.'' Like other analysts, he criticizes management for failing to commit to a
specialty focus that's less prone to precipitous falloffs in customer capital spending — opting instead to be ``all things to
all people.'' ``With that kind of approach,'' Denney adds, ``you will continue to lag when firms like Lucent (NYSE:LU -
news) post weak results.''
Flextronics, by comparison, is anything but confused. It's the undisputed leader in the low-cost, high-volume wireless
and consumer electronics markets. According to David MacGregor of Midwest Research, Flextronics manufactures
10% to 15% of all wireless handsets in the world, counting on telecommunications equipment contracts for only 25% to
30% of sales (competitors often have 50% to 75% exposure to the beleaguered sector). As demonstrated by Best Buy's
(NYSE:BBY - news) Tuesday announcement of a 40% profit surge, things may not be so bad in consumer electronics.
In addition to still-growing cell-phone producers, Flextronics also counts as a big customer none other than Microsoft
(NASDAQ:MSFT - news), which called on the Singapore-based company to build its X-Box gaming unit.
The secret to its success: mastering the art of vertical integration. Save for the rawest of raw materials, Flextronics largely
depends on itself for components — a huge competitive advantage at a time when rivals are realizing they ordered too
many parts in the past year. It also allows the EMS giant to offer clients faster turnaround times on contracts. Time and
money are of the essence in an industry that has to be able to market increased efficiency to manufacturers contemplating
the economies and logistics of outsourcing.
``Flextronics can truly say it's a one-stop EMS shop,'' says Midwest's MacGregor. ``That's a huge reason why it should
trade at a premium to the group.'' Denney is even more impressed that the company has pulled in $5 billion to $7 billion
in new orders — money in the bank that'll continue to buffer it against a sluggish global economy.
At $25, the stock trades at 39 times Thomson Financial/First Call's mean profit estimate for 2002 (a modest premium to
its projected growth rate of 30%). Unlike Solectron, Flextronics said in late November that it was comfortable with Street
estimates.
Then there's San Jose, Calif.-based Sanmina, which by virtue of its recently completed acquisition of competitor SCI has
pruned its exposure to the telecommunications market to 40% of revenues from 72%. It also trades at 39 times expected
2002 earnings. The big story here is Sanmina's effort to ride an imminent industry shift toward high-density optical
switches. Specifically, the firm is gearing up to mass produce Nortel Network's (NYSE:NT - news) HDX switch, a
much anticipated high-traffic model. Having already won that lucrative deal — and also expected to be a major
beneficiary of Cingular's wireless build out — Sanmina is hardly sitting around waiting for a telecom spending rebound.
Earlier this month, on an upbeat conference call discussing Sanmina's integration with newly acquired SCI, management
mentioned that it's considering taking on as many as seven contracting projects. The company also raised its fiscal 2002
projection for cost savings from the deal to $200 million from a previous $100 million to $150 million. It, too, has
committed itself to vertical integration.
These contract manufacturers' customers ``are consolidating their outsourcing to a smaller base of companies,'' notes
MacGregor, who thinks Sanmina and Flextronics's sector-busting size and multidimensional capabilities will woo
equipment makers away from smaller niche players. ``'Where can I get the most and save the most?' is the question of
the times,'' he says.
That's a question the likes of Sanmina and Flextronics may have the answer to.
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