Markets & Finance

Two Gems Amid Tech's Dross


By Richard Stice, CFA The enormity of the collapse in technology stocks this year has been stunning. Many small and less financially stable companies have been wiped out completely, and even some industry leaders have seen their share prices fall below $5. Given this backdrop, many investors are understandably skittish about a group of companies that may never return to the lofty levels reached in 2000. One area that may interest risk-tolerant investors, however, is the electronic manufacturing services (EMS).

While this group has certainly not been immune to the industry slowdown, with share prices of several EMS outfits down 50% to 90% this year, we believe significant growth potential still exists. A recent study conducted by International Data, a market-research outfit, concludes that EMS sales will grow to $123 billion by 2006, vs. the $86 billion expected in 2002. The decision to hire EMS companies to take over product manufacturing is becoming an increasingly attractive alternative for original equipment manufacturers (OEMs).

There are two primary benefits to this strategy. First, OEMs can cut costs by closing or consolidating facilities and reducing headcount previously devoted to the manufacturing process. Second, by outsourcing nonstrategic business functions, OEMs are able to devote more of their resources to research and marketing efforts, strengthening their competitive position.

EMS industry fundamentals are improving, as inventory levels have declined considerably, orders for printed circuit boards (a measure of strength) are well above the lowest levels, and the production of goods is being shifted to lower-cost regions of the world. Plus, many companies are placing greater emphasis on consumer electronics, medical, and industrial markets to become less reliant on the dismal telecom industry.

MARKET SHARE. From an investment standpoint, many EMS stocks are at or near historical lows in terms of valuation metrics, including price-earnings (p-e), p-e-to-growth, and price-to-sales ratios. But the important barometer to watch when assessing EMS companies is market share.

Many OEMs have begun to reduce the number of manufacturers they are willing to work with in order to achieve more streamlined production, which reduces costs. This trend should allow the top EMS players to win the majority of new business, since their smaller rivals cannot match the breadth of services offered by their larger competitors. The five largest players -- Celestica (CLS), Flextronics (FLEX), Jabil Circuit (JBL), Sanmina-SCI ( SANM), and Solectron ( SLR) -- which together control approximately 60% of the industry, have a distinct advantage in this regard.

We at S&P believe three of the leaders -- Celestica, Flextronics, and Jabil Circuit -- have the fundamentals in place not only to weather the economic slowdown, but also to prosper once end-markets improve. Celestica differentiates itself through its advanced capabilities in technology, quality and supply-chain management. Its facilities are organized as customer-focused factories, with dedicated manufacturing lines and customer teams. The Canadian company's large size, geographic reach, and expertise in supply-chain management allow it to purchase materials at a lower cost, and deliver products to customers faster, reducing overall product expenses and time to market for OEMs.

ROBUST BALANCE SHEET. Celestica shares have declined sharply in recent weeks, in part because the company warned that third-quarter results would be lower than anticipated. We continue to believe, however, that its industry position and strong balance sheet (with $7 per share in cash and short-term investments) make it a compelling investment opportunity. For 2003, we are targeting revenue growth of approximately 20%, to $10.3 billion, and cash EPS of $1.42, up from an estimated 95 cents in 2002. Trading at about $12.42 on Oct. 11, or 8.7 times our 2003 EPS estimate, with a p-e-to-growth ratio of 0.3 -- both significant discounts to its peers and the broader market -- we believe Celestica (ranked 4 STARS, or accumulate) is attractive for above-average capital appreciation.

Flextronics, the largest contract manufacturer, provides services to the telecom, networking, computer, consumer electronics, and medical industries. Services range from initial product design, to volume production and fulfillment. It also provides engineering services such as design and test development, as well as logistics services, including materials procurement, inventory management, packaging and distribution.

To improve profitability in what is generally a low-margin business, the Singapore-based company has been aggressively moving its manufacturing facilities to lower-cost regions of the world such as Asia, Eastern Europe, and Latin America. Now that Flextronics has about two-thirds of its production located in these areas (the highest of any EMS company), it should be able to reduce operating expenses and increase earnings, despite tepid demand. This strategy also gives it the ability to significantly boost market share, since it can offer more favorable terms when bidding for new business than its rivals.

PEER DISCOUNT. Flextronics shares have declined almost 70% so far this year, closing at around $7 on Oct. 11, amid end-market weakness, particularly in the telecom sector. But given its size and low-cost manufacturing capabilities, we think Flextronics will be able to withstand any prolonged industry downturn. In fiscal year 2003 (ending March), we anticipate revenues rising about 2%, to $13.4 billion, and cash EPS of 37 cents, vs. 61 cents in fiscal year 2002.

On a valuation basis, the shares are trading at a discount to their peers in terms of price-to-sales, and they are below the broader market on both a p-e and p-e-to-growth basis. With a favorable cost structure and attractive valuation, S&P views Flextronics (ranked 4 STARS, or accumulate) as a stock that should outperform the broader market over the next 6 months to 12 months.

Jabil Circuit produces goods for the international personal-computer, computer-peripherals, communications, automotive, and consumer markets. The St. Petersburg (Fla.)-company offers a complete software and hardware solution, including circuit and production design, component selection, automated assembly, and repair and warranty services. Jabil is able to provide its services for a relatively low total cost by utilizing efficient production methods, through its use of less expensive components, and the low-cost regional locations of its factories.

FREE CASH FLOW. Although Jabil shares have fallen by around 45% so far this year, closing at $13.25 on Oct. 11, they have outperformed those of their primary competitors. We forecast an 18% rise in fiscal 2003 (ending in August) revenue, to $4.2 billion, and EPS of 75 cents, vs. 46 cents in fiscal year 2002.

Based on our expectations, the stock trades at a modest premium to its peers when comparing p-e, p-e-to-growth, and price-to-sales ratios. Jabil continues to execute well, as its days sales outstanding (accounts receivable divided by sales for the period, which is divided by the number of days in the period) and inventory turnover ratios (cost of sales divided by the average inventory level) have improved from a year ago, and is a solid generator of free cash flow.

Given its current valuation, however, we believe those factors are already reflected in the share price. As a result, we rank Jabil 3 STARS, or hold, and expect it to perform in line with the broader market over the next 6 months to 12 months. Analyst Stice follows electronic manufacturing services stocks for Standard & Poor's


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