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1/9/2004
04:03 PM
William Schaff
William Schaff
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Taking Stock: Flextronics' Stock Still Reasonably Priced

William Schaff says that after staggering through a long, dark tunnel, electronics-manufacturing-services providers are finally seeing daylight.

After staggering through a long, dark tunnel, electronics-manufacturing-services providers are finally seeing daylight. While semiconductor, networking equipment, and hardware vendors all saw their stock prices at least double in 2003, EMS leader Flextronics still offers a reasonable price as business ramps up.

Years ago, this industry offered low-cost, simple manufacturing to technology companies. Over the years, the offerings have become more sophisticated and now include research and development and original-design manufacturing, where the vendor develops the product from start to finish and the customer's name is stamped on the cover.

Demand for EMS services heated up in the late '90s as business soared at companies such as Cisco Systems, Hewlett-Packard, and Sony. To better meet demand and to focus on their core competencies of product design and marketing, tech companies increasingly outsourced to EMS providers.

The downturn left EMS companies with an enormous amount of excess capacity, and their stocks plummeted. Over the last two years, that capacity has been shut down; eight major companies have been acquired and six have gone bankrupt. Only nine significant companies remain, and consolidation is likely to continue.

In 2003, Flextronics, the largest of these companies, began to see signs of life from its customers and won new customers. Now it's expecting profit margins to improve because of increasing demand, as well as the high-margin original-design-manufacturing business and plans to turn around its money-losing printed-circuit-board business.

Flextronics competes with some excellent, but slightly smaller, competitors, including Celestica, Jabil Circuit, and Solectron. Flextronics has a more diversified customer base than its peers, and its business mix is one of the most diverse, so it offers a more-consistent business model.

Risks are considerable in this cyclical business, and its capital-intensive nature has made attaining profitability difficult in the downturn. Companies are at the whim of their customers' business fortunes. Flextronics' low-technology products include cell phones and handheld devices, which, while they're high growth, exposes them to low-end competition from China.

Pro forma operating margin in the second quarter was only 2.1%. Earnings per share for the 2004 fiscal year, which ends March 30, is expected to be 35 cents. Given that margins should substantially improve over the next few quarters and revenue is bound to rise, next year's expectation of 55 cents earnings per share is likely to be achieved or surpassed. The forward price-earnings ratio is 27 times, which compares with the Nasdaq 100's 30 times, Flextronics' long-term historical average of 37 times, and its peer group's average of 30 times. I believe there's room for multiple expansion and earnings could easily exceed current expectations. EMS may be a boring business, but if things go Flextronics' way, the stock should be fairly exciting.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at bschaff@bayisle.com. This article is provided for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security. Bay Isle has no affiliation with, nor does it receive compensation from, any of the companies mentioned above. Bay Isle's current client portfolios may own publicly traded securities in one or more of these companies at any given time.


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To find out more about William Schaff, please visit his page on the Listening Post.

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