Flextronics Breaks the Mold


By Sam Jaffe The concept of contract manufacturing began as a form of insurance against demand overrun. Technology companies could pay contract manufacturers to step in when their own factories reached full capacity. For a slim cut off the top, contract companies like Solectron (SLR), Jabil Circuits (JBL), and Celestica (CLS) would make their products.

Of course, that wasn't a very promising business model for the contractors, which had to pay for plants that sat idle during down times. The stocks of such companies used to follow the ups and downs of the chip cycle: When things overheated, Wall Street bought the stocks, and when business died down, it sold them.

Thus it stands to reason that now should be a bad time to own contract manufacturers. Thanks to a drastic downturn in demand for electronics equipment, ranging from telecom gear to PCs to personal digital assistants (PDAs), most contractors are running at extremely low levels of capacity -- and most of their stocks are at 52-week lows. But it might be a very good time to own Flextronics (FLEX).

X-BOX MARKS THE SPOT. What's different about Flextronics? The X-Box -- the game machine that will be shipped in November under the Microsoft (MSFT) name. Although built by Flextronics, the success or failure of the X-Box won't have much bearing on the company's overall fortunes -- contributing just a minor portion of its $12 billion in revenue. What is important is that the X-Box will be the first major consumer electronics device designed as much by a contract manufacturer as by the company that has its brand on it.

Flextronics helped design the X-Box and will assemble, package, and ship it. The only thing the company won't do is market the game machine. This is the future of contract manufacturing -- and Flextronics has taken a quick lead in such complete-service packages. The company also has signed deals with Ericsson (ERICY), to design, build, and ship its cell-phone handsets, and Alcatel (ALA), to do the same for some of its telecom equipment.

Such a strategy has inherent risks. Traditionally, the contract manufacturer didn't shoulder the high cost of paying a full design team, with responsibility for understanding the intricacies of consumers' tastes as well as industrial design. In fact, Flextronics is beginning to resemble the OEMs (original equipment manufacturers) that it promises to replace.

"NO INVENTORY RISK." There is one important difference, though. Because it is not involved in marketing, Flextronics doesn't have to take on the responsibility of stocking its warehouse shelves with product. "We take no inventory risk," says CEO Michael Marks. "We have a 20-page contract that every customer signs which can be summed up in one line: We take no inventory risk."

That also means Flextronics won't benefit as greatly if, for instance, the X-Box is a rousing success. While Microsoft will enjoy higher margins for each extra box sold, Flextronics' revenue will increase only in relation to the higher volume of shipments. But in this slow economic environment, the lack of inventory risk outweighs any such problem.

Witness what has happened to the stock prices of companies that have taken large inventory write-offs, such as Cisco. Its shares are in the basement.

"MAJOR PLAYER." While all contract manufacturers have in-house design teams, Flextronics is clearly a leader in providing complete design help to customers. "What they did in the past is just now being validated by their competitors," says AG Edwards analyst Tony Boase, who has a buy rating on the stock. "They are definitely the trailblazer in the design area."

Another area Flextronics can brag about is its size. Thanks to several dozen acquisitions in the past few years, it's now the second-largest contract manufacturer, behind Solectron. Flextronics is just starting to reach critical mass, says Robertson Stephens analyst Keith Dunne, who also rates the stock a buy. "It used to be that suppliers would only cut deals with OEMs, but now they're recognizing Flextronics as one of the major players, and they are coming to them with big discounts."

That's important, because materials costs comprise 76% of the expenses for the average device made by Flextronics. The company's new-found buying power can cut as much as 4% off a product's costs.

CELLULAR CLEAR SAILING? The cellular handset market, which accounts for 49% of the company's revenue, is by far the most significant sector Flextronics participates in. Despite the market's massive drop-off in 2001, the company should still be able to finish the year without losing money, says Marks. He also thinks the worst is over as far as the depression in handset sales in Europe, which led the slowdown.

"They had as many as 50 million handsets clogging the channel earlier, and now they're at 20 million. That's down to a level for them to start ordering more," Marks says. Thanks to its partnership with Ericsson, Flextronics is the third-largest handset maker, after Nokia (NOK) and Motorola (MOT).

Not everyone is convinced. Douglas Thomas, an analyst with Irvine Capital Management, says he has sold all his contract manufacturing stocks, including Flextronics. He questions the premise behind the entire industry. "If making these things was a good business to be in, then why do all these companies fob it off to contract manufacturers," he says. "It's a fairy tale that this is a hot growth industry. The current downturn is going to last a long time for these guys. I'd rather own a food company."

"BIG BREAKOUT." His opinion is a lonely one on Wall Street, which is enthusiastic about the long-term viability of the sector, if not its short-term momentum. But the short term might actually shine for contract manufacturers.

The sector's last great year was 1992, when the five companies that comprised it were up a collective 119%. That was a year after the last recession -- a time when a lot of large corporations decided to start outsourcing their manufacturing. Marks thinks the same will hold true for the second half of this year or the first half of 2002. "The next 12 months will see a big breakout in new orders," he says.

If that turns out to be true, Flextronics' stock likely would be appealing to investors looking for a bargain. As of the close of trading on July 26, it was at $25-and-change per share. That gives it a 2002 price-earnings ratio of 31. Not bad for a company expected to see earnings increase at a rate of 20% a year for the next five years. Jaffe writes about the markets for BusinessWeek Online in our daily Street Wise column

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