Markets & Finance

Riding Tech's Tailwind


Thanks to strength in many technology stocks lately, various electronic manufacturing services (EMS) names are also doing well. Flextronics (FLEX), Jabil Circuit (JBL), and other EMS outfits make handsets, computers, printers, consumer appliances, and other electronic products for companies such as Motorola (MOT), Hewlett-Packard (HPQ), and IBM (IBM).

Richard Stice, CFA, who follows EMS companies for Standard & Poor's Equity Research, has a neutral fundamental outlook for the group, but sees plenty of positive trends. The outsourcing of manufacturing still has a lot of room for expansion, he says. EMS companies are finding opportunities in new sectors, such as auto and medical equipment, which can offer fatter margins. They also collaborate with their customers on product design. Plus, many EMS companies have undergone restructurings that have streamlined their manufacturing operations.

BusinessWeek Online's Karyn McCormack recently spoke with Stice about the EMS industry and his favorite stocks. Edited excerpts of their conversation follow.

Note: Richard Stice (CFA) is a Standard & Poor's Equity Research analyst. He has no ownership interest in or affiliation with any of the companies on which he reports. All of the views expressed here accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this story.

EMS stocks have been strong lately. Why?

So far this year, through Feb. 10, the group is up 8.7%, which is a healthy outperformance vs. 1.9% for the S&P 1500. Conversely, in 2005, the group was down 8.3%, and the S&P 1500 was up 3.8%.

The move up has largely been driven by the broader market, especially strength in tech stocks. It's also been driven by earnings. For the group, I'd say the latest earnings reports were mixed. But broadly, technology did well in the fourth quarter, and that tends to drive these names up. Companies like EMC (EMC) and IBM (IBM) reported solid numbers, which bodes well for EMS companies.

Some EMS stocks are doing better than others. Why has Flextronics been weak?

Flextronics shares were flat in January, and have declined this month. We think there are three main reasons. The company has an agreement with Nortel Networks (NT) to manufacture optical equipment and other telecom-related items. However, some of the assets that Flextronics was supposed to acquire during the March quarter are being delayed until the June quarter. The company says that as a result, it will lose a penny a share in both the March and June quarters.

The second reason is the lack of projected growth in producing designed handsets during fiscal year 2006. The company expects to make 4 million handsets, which would be flat with fiscal 2005. But in 2007, the company expects growth to resume as its design group plans to produce up to 11 million phones. Handset customers are Kyocera, which is a fairly recent addition, Motorola (MOT), and the joint venture of Sony Ericsson.

The third reason relates to a recent law change in Singapore, where the company is based, that will allow it to repurchase its shares. I believe the market may have been anticipating the unveiling of stock buyback program by the company. This did not materialize, so it may have been perceived by some as a negative development.

What's the major trend for EMS companies?

It's the pursuit of nontraditional markets, such as the auto and medical areas. There are significant growth opportunities, and these areas also tend to have higher margins. Plus, the medical side tends to be less seasonal than other industries currently partnering with EMS providers.

We believe that one of the favorable aspects of these sectors is the strenuous safety regulations set forth by the federal government. We think this provides a formidable barrier to entry for existing EMS providers who are already working with particular customers or products.

In terms of the growth projections, IDC says that from 2004 to 2009, the compounded annual growth for EMS companies making auto products is 26.3%, while medical products is 35.8%. Examples of the types of auto products include audio and navigation systems and systems control modules. On the medical side, it can be X-ray equipment, MRI scanners, ultrasound monitors, and even scalpels.

Which companies are making auto and medical products?

All of the major players are in engaged in one if not both of those segments. Except for one company, the revenue from those areas accounts for a small portion of overall revenues -- usually less than 10%. The one exception is Plexus (PLXS), which gets 30% of revenue from the medical field.

The auto industry isn't in very good shape right now.

Obviously, that could be a problem. On the other hand, it presents an opportunity for the EMS companies given that auto makers are trying to cut costs. Outsourcing the manufacturing of certain equipment could result in a more competitive and streamlined automotive industry, while providing additional business for the EMS providers.

Which stocks do you like?

We have three buy-recommended stocks -- no strong buys at the moment. The first one is Jabil Circuit (JBL). Our opinion is based largely on consistent execution. It is gaining market share. Its revenue growth projection is north of 20% for fiscal 2006, and most of that is organic. Its gross and operating margins exceed the peer average. And its free cash flow has averaged over $300 million for each of the past four years. Our 12-month target price is $44, derived via relative price-earnings and discounted cash flow (DCF) analyses.

The second is Benchmark Electronics (BHE), which focuses on storage equipment, servers, and other tech equipment. The same thing here: above-average execution and margin performance. It is also expanding its customer base. Sun Microsystems (SUNW) is its largest customer -- it was 32% of revenue in the fourth quarter of 2005, down from over 50% at the end of 2002. EMC is also a big customer.

We think it has financial strength -- no long-term debt and over $7.50 a share in cash and investments. Our 12-month target on the shares is $44, based on discounted cash flow and relative p-e to growth.

The third is Flextronics, which relative to the other two is more of a turnaround story. It still has the leading market-share position in the industry. There are a number of potential synergies with the Nortel deal. The company expects an annual revenue run rate of about $2 billion once the assets are fully ramped. Its design handset business is expected to grow from 4 million to 11 million in fiscal 2007.

I'm also encouraged by Flextronics' lower debt levels and improving free cash-flow generation. So far in fiscal year 2006, the company has generated approximately $500 million in free cash flow -- that exceeds the total for all of fiscal year 2005. In terms of valuation, the stock trades below peers on a p-e, p-e-to-growth and price-to-sales basis. Our 12-month target price is $13, derived on relative price-to-sales and DCF analyses.


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