cnbcs140

Electronic Mfg Group Seen as Good Bet


By Hal Plotkin
Silicon Valley Correspondent

Analysts say quarterly earnings reports from Solectron Corp. {SLR} and Jabil Circuit Inc. {JBL} this week will generate increased attention for stocks in the highly volatile but upwardly mobile electronic manufacturing services (EMS) sector.

“Solectron’s stock went up almost 40 percent in the week, after the company announced its last quarterly earnings in March,” notes J. Keith Dunne, an analyst at Robertson Stephens in San Francisco. “I think we could be in the same kind of déjà vu position all over again.”

Solectron Monday released its fiscal third-quarter earnings for the period ended May 26 of 21 cents a share, in line with analysts’ consensus estimates, according to First Call Corp. Those earnings excluded one-time items.

Jabil Circuit’s quarterly earnings are also expected to come in at 21 cents a share when the company reports numbers for its fiscal third quarter, ended on May 31, later this week. Both companies posted earnings of 15 cents a share for the same period a year earlier.


Jabil 52-Week Stock Chart

Solectron 52-Week Stock Chart

Almost identical movements in Solectron and Jabil’s stocks, along with competitors SCI Systems Inc. {SCI} and Flextronics International Ltd. {FLEX} has made the leading stocks in the EMS group look like Siamese twins in recent months.


SCI Systems 52-Week Stock Chart

Flextronics 52-Week Stock Chart

“The stocks do tend to move in tandem,” Dunne says. Last month, for example, rumors of shortages of some components put pressure on all four stocks. They quickly turned around, however, after analysts rallied to their defense by pointing out, among other things, that lower revenue for contract manufacturers, in the unlikely event they do occur, wouldn’t necessarily translate into lower margins or earnings, due to the elastic cost structure of such firms.

“Twenty percent of the labor help is temp,” Dunne says. “That means the companies can miss the top line and still hit their bottom line.”

Despite its high volatility, analysts appear to universally favor the EMS sector, especially in the current investment climate.

Several major telecommunications companies, including Lucent Technologies Inc. {LU}, Motorola Inc. {MOT} and Nortel Networks Corp. {NT} have all recently announced dramatic increases in outsourcing their manufacturing. The telecom companies join the ranks of other big electronics and computer system and component makers that have already realized that letting another company assemble their products is an excellent way to keep costs under control and margins high.

As a result, EMS companies are enjoying demand from an increasingly diverse group of customers, which leaves them relatively immune to normal product cycles or downturns in any individual technology markets.

“EMS companies with a diverse list of customers are extremely well-positioned,” says Shelby Fleck, an analyst with Morgan Stanley Dean Witter in New York. “If one customer is doing poorly and pulls back, there are always others doing better.”

Fleck names Solectron as her current top pick in the sector. She has a “strong buy” recommendation on the stock, her firm’s highest rating, but is keeping her price target under wraps, at least for the moment. The analyst is, however, willing to say that the stock trades below her 12-month target.

Solectron’s stock, which typically trades at a premium compared with others in the group, lost some of its luster in recent months because of worries over delays in some pending acquisitions. Analysts say the pullback has created a buying opportunity.

“Solectron has had a steadier performance than many others and has a diversity of customers,” Fleck says. “I like to pick my spots and move in whenever the valuation pulls back to attractive levels.”

Fleck has “outperform” ratings, her firm’s highest “buy” rating, on the three other leading EMS stocks, Flextronics, Jabil Circuit and SCI Systems. “We like them all,” she says.

Dunne also likes Solectron’s stock and says worries about the delayed acquisitions are overblown. “When everyone thinks the sky is falling, that’s the time to buy the stock,” he says. “Solectron is a very well-run company.”

Even so, Dunne says he is even more enthusiastic about Flextronics’ stock at the moment.

He slapped a “buy” rating on the stock, with a 12-month price target of 85, last Tuesday after Motorola Inc. {MOT} announced it would outsource $30 billion in manufacturing to Flextronics over the next five years.

“Jabil has had the best run lately,” Dunne says. “But the Motorola-Flextronics announcement is really big news. It’s a substantial win for the company.”

James Savage, an analyst at Thomas Weisel Partners in New York, won’t comment on the prospects for Flextronics’ stock because his firm is involved in the pending secondary Flextronics’ stock offering. But he says SCI Systems and Jabil Circuit are his top picks among the three remaining leading EMS stocks.

Last year, SCI Systems forged a relationship with Nortel that is moving the company past its low-margin roots in the PC assembly business and into the more-lucrative telecommunications terrain.

Likewise, Savage says it looks like Jabil Circuit will be the primary beneficiary of Lucent’s decision to outsource as much as $10 billion in manufacturing over the next two years.

“We think Jabil can grow at 30 to 35 percent, maybe even 40 percent, over the next year,” Savage says. “We also think SCI is trading at a substantial discount to its peers. The company’s margins are going up, and they are a primary supplier of optical [manufacturing and assembly] facilities to Nortel, which is growing like there’s no tomorrow.”

Savage has “strong buy” ratings on all four stocks, with 12-month price targets of 60, 60, 54 and 75 for SCI Systems, Solectron, Jabil Circuit and Flextronics, respectively. The Flextronics target was published prior to the commencement of that firm’s “quiet period,” related to its pending secondary offering.

Jerry Labowitz, first vice president at Merrill Lynch in New York, also puts SCI Systems very high on his list.

“We believe SCI Systems is making positive changes, including a shift to more communications business, new management hires and a more-aggressive acquisition strategy that should result in a higher growth rate,” Labowitz wrote in a research note published earlier this week.

On Wednesday, Labowitz reiterated his “long-term buy” rating on SCI Systems’ stock and $60 12-month price target. “SCI has the cheapest multiple,” he says. “But it depends what kind of an investor you are.”

An investment in SCI Systems could, Labowitz says, be more speculative because the company has relatively fewer customers than some of its competitors. But the stock could also have the most upside potential.

Labowitz also notes that Solectron, like rival SCI Systems, is also benefiting from Nortel’s outsourcing plans, having recently purchased four manufacturing facilities from the firm which will be used for high-margin telecom product assembly.

“All these companies are doing a very good job,” Labowitz says. “An investor just needs to see which one of them they feel more comfortable with.”

The analysts also say that investors who buy the leading EMS stocks should also get comfortable with the sector’s extreme volatility, which they see continuing.

Over the past few years, for example, stocks in the overall EMS sector have gyrated wildly, with the average high-to-low prices moving in a 300 percent range during a time frame when the stocks have gone up on average, as a group, about 80 percent each year, according to a recent Robertson Stephens report.

“You have to realize this is a very, very volatile group,” Dunne says. “That’s why it’s important to keep your eye on the long-term trend, which is very positive.”

“These are naturally volatile stocks,” says Roger Norberg, an analyst at Chase H&Q in Minneapolis. “But we like the group very, very much based on fundamentals.”

“We see the group outperforming as a whole,” Savage adds. “Every time there’s been a selloff in this group over the past five years, it’s been followed by a period of out-performance.”

Flextronics International and SCI Systems are slated to release their fiscal third-quarter earnings reports July 17 and August 7, respectively.

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