Sector Scope by James A. Anderson May 10, 1999

High-Tech Contract Manufacturers: Low Profile, High Potential
Companies like SCI Systems, Solectron, and Jabil Circuits make billions handling the production of everything from pagers to laser printers

These days, a lot of tech companies seem to hate getting their hands dirty. An IBM, Nokia, or Cisco Systems doesnít mind slaving away at the workstation until it perfects a new design -- and then wearing down shoe leather to market it. But when it comes to soldering circuit boards, more and more companies prefer offloading the grimier work to someone else.

As more tech outfits have made that choice, a $112 billion business has materialized worldwide for contract manufacturers with names like SCI Systems (SCI), Solectron (SLR), and Jabil Circuits (JBL). In fact, companies in this industry routinely are called in to handle the production of everything from pagers to laser printers, from cell phones to computer workstations. And as a growing list of telecommunications equipment, computer, and electronics makers hire outside help, revenues of leading contract manufacturing companies are growing by up to 60% a year. That sort of groundswell leads Technology Forecasters, a consulting firm in Alameda, Calif., that tracks the industry, to predict that its sales will grow 25% to 30% a year, to $180 billion by 2001.

Those are projections that Wall Street canít help but notice. The 25 stocks in the Banc Boston Robertson Stephens index of contract manufacturers have risen nearly 110% over the past 12 months, vs. 23% for the Standard & Poorís 500, though the group is up only 7.5% this year vs. 9.2% for the S&P 500.

QUICK TURNAROUND. Indications are that the orders will keep coming in, if only because cutthroat competition and the steep price of building and retooling factories are forcing tech companies to rethink how they get their wares to market. "A lot of [high-tech product] designs are meant to be replaced in 18 months or less" says Mark A. Giudici, an analyst with Dataquest. "When you factor in the cost of a fab [chip plant] being between $500 million and $1 billion, itís enough to scare some people off."

Contract manufacturers, though, have done more than roll up their sleeves and tool away on circuit boards. For one, theyíve helped clients shorten the time it takes a design to get to market once it leaves an engineering team's hands. "The demand to get data communications equipment, switches, and workstations out in a hurry is great," says Credit Suisse First Boston analyst Herve Francois, who adds that contract manufacturers are experts at streamlining production. "What recently took a year or so to get to market now can be done in a matter of months," he adds.

Companies in the sector also have been busy trimming costs. Some, for example, have struck bargains to take over second-hand facilities from their customers at a fraction of the original price -- while agreeing to deliver the output to the original owner. That way, a wily contract manufacturer can both save money and gain additional capacity for serving other clients. Last year, for instance, Solectron took over factories from IBM, NCR, Ericsson, and Mitsubishi while signing production contracts with the former owners.

ROOM TO GROW. Contract manufacturers also have expanded their role beyond production. While in the recent past, a typical outsourcing job was limited to noncritical components, contractors are now often called in as design partners for new products. Cementing those types of ties with companies such as Hewlett-Packard to Cisco bodes well for companies that can pull it off.

Analysts also say the group has plenty of room to expand. Key players in growth industries such as telecommunications equipment farm out only about 20% of their production. That figure could rise to 30% or 40% in the next three to five years for companies such as Lucent Technologies, Nortel, and Ericsson, according to J. Keith Dunne, an analyst with Robertson Stephens.

Of course, it's wise to remember that a contract manufacturer is only as bulletproof as its clientele, with its earnings following the same peaks and troughs as those of its customers. With PC demand iffy right now, for instance, the greater a manufacturerís exposure to the sector, the more difficulty itís likely to have hitting Wall Streetís earnings projections. That was certainly the case with SCI Systems, which alerted analysts earlier this year that it would fall short of revenue and earnings expectations in its March and June quarters. Value Line analyst David M. Rosenfield says that could well reflect weakness in the PC businesses of two major customers, Compaq and HP.

Francois prefers companies such as Solectron, which in addition to making PCs turns out network equipment, mobile phones, and telecom equipment. The company has brought on several major customers over the past few months, including IBM and NCR, leading Value Line analyst Bryan W. Keane to project that the company's revenues will grow more than 50% this year. Currently, 11 of 17 analysts who follow the stock rate it a buy or strong buy, and Wall Streetís consensus view is that Solectron is on track for 28% average annual earnings growth over the next five years, according to Zacks Investment Research. "The company is a consistent performer, and has proven management," says Berkeley S. Belknap, a portfolio manager for the First Mutual Fund.

HIGH-MARGIN PRODUCTS. Analysts also like a couple of niche players, companies that have homed in on high-margin projects such as backplanes, the sandwiched circuit boards that are a component of switches and other telecom equipment. Francois likes Sanmina (SANM), which has a 60% to 70% share of the backplane business and which last December bought its No. 2 competitor, Altron. "Theyíve positioned themselves to win a good amount of business when telecom equipment makers come calling," he says. Of the 15 analyst who follow Sanmina, 14 rate it a strong buy or buy, and Wall Street estimates that the company's earnings will grow an average 29% a year over the next five years, according to Zacks.

Another Wall Street niche favorite is Jabil Circuits (JBL), which makes networking equipment and has relationships with Cisco Systems and 3Com. Jabil is rated a buy or strong buy by 21 of the 23 analysts who follow it, according to Zacks. And since 45% of its business comes from computer networking contracts, Wall Street feels the company could garner 26.5% average annual earnings growth over the next five years, according to Zacks. One potential vulnerability, though, is that nearly half of the companyís sales come from its five largest customers, says Value Line analyst Seaver T. Wang.

Mutual-fund investors will find that while no one portfolio focuses exclusively on contract manufacturers, several funds have a decent weighting in the sector. The Fidelity Select Electronics Fund (FSELX), up 10.05% so far this year, had a total return of 44.70% over the past 12 months. The fund has averaged a total return of 32.57% over the past three years. Then thereís the First Mutual (FMFDX) fund, which has a broader-based portfolio but a heavy tech bias, according to Morningstar Inc. The fund, which currently has 5.5% of its assets in Solectron, is up 16.27% so far this year and has averaged a total return of 42.78% over the past 12 months and 26.04% over the past three years.

James Anderson, who teaches journalism for the City University of New York, writes Sector Scope every other week

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