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The Tech Slump's Next Victim?

Look quickly and you might glimpse the last tech stocks still standing. The shares are those of electronics contract manufacturers--companies that have grown dramatically by catering to the out- sourcing desires of brand-name gear vendors from Cisco to Dell to Motorola. They prominently include Solectron, Flextronics, and Celestica. Their stocks have held up so far, but they look as if they may be the next dominoes to fall.

The issues gained 10% during the 12 months through January--while technology stocks in general lost an average of 33%, according to UBS Warburg. The group was one of only two winners out of 12 tech categories. Celestica Inc. was up 76%. Flextronics International Ltd. stock was up 60%--and on Feb. 1 the company issued $1 billion in new shares.

UNSAFE HAVEN. But a closer look shows the stocks in peril, even if the outsourcing trend is destined to survive in the long term. The problem is that despite their growth rates, the companies' financial results are unimpressive: flat or heading down. And in at least one case--Flextronics, the second-biggest and fastest-growing such company--details in financial reports to the Securities & Exchange Commission show weaker results than described in press releases and statistics posted on the Internet.

Up to now, Wall Street and the companies were successfully selling the shares as a recession haven. The rationale: In tougher times, the companies would pick up even more factories and contracts as their customers swore off the fixed costs and capital required to manufacture. Flextronics and Celestica have snapped up factories, turbocharging their revenue and earnings growth as much as 60% year-to-year. The industry is projected to grow to $149 billion in 2003, from $88 billion in 2000, notes UBS. Customers sold off $9.4 billion of facilities in 2000, up from $2.6 billion in 1999, as they tried to be more "virtual." Flextronics' factory space now occupies 17.6 million square feet, up from 1.5 million three years ago.

The growth has supported the shares, giving the companies the funds to buy more factories. In 2000, Wall Street underwrote $13 billion of stocks and bonds largely to finance additional contract business. The story played well, casting the companies as corporate manifestations of the trend toward specialization of labor and higher productivity.

But the image is better than reality. Inventories are turning over more slowly than several quarters ago. Supposedly the problem is being fixed, but some companies have expanded so fast they are having trouble keeping track of supplies. Executives at chip supplier Altera said in a recent conference call with analysts that contract manufacturers couldn't tell them how many of their products were stocked at their factories because information systems weren't being updated fast enough to keep up with plant acquisitions. Net profit margins for the industry, about 3% to 5%, have been wavering, even as business boomed at a time when the industry should have delivered higher operating rates and economies of scale. Returns on assets, generally about 8%, are under pressure as capital pours in. "Contract manufacturing is a terrible business because the returns on capital are fairly low, given all the risks they've taken on," says David W. Tice, a short-seller and manager of Prudent Bear Fund.

To be sure, the companies acknowledge that growth alone won't ultimately satisfy investors. For example, Celestica tells employees that a key financial goal is improving returns on invested capital.

Meanwhile, opinions of the stocks are turning down. Analysts are cutting earnings estimates. The worry: that the tech slump will hurt in the next couple of quarters regardless of the outsourcing trend. In the three days after an earnings warning from customer Nortel Networks Corp., Celestica shares fell 26%, to $52.45, or 25 times estimated 2001 earnings.

Investors looking for reassurance will find little evidence that the revenue growth will be sustained. Flextronics' deal in January to operate factories for Ericsson's handset business, for example, does not include revenue guarantees, according to filings with the SEC. In any case, such deals are not likely to be lucrative because contract manufacturers will tend to be offered only the low-margin, capital-intensive leftovers.

Another threat is all the capital Wall Street has funneled into the industry. It has fueled competition and set the stage for price-cutting. That may help explain why profit margins haven't climbed.

DETAILS. Most disconcerting, Flextronics' financial reporting is at best inconsistent and can lead to disappointment. The company said in its Jan. 18 press release that in the December quarter it had earned 26 cents a share--a penny better than analysts' estimates and up 73% from a year before. But the bottom line in the 10-Q quarterly report filed later with the SEC was only 14 cents. Why was it 12 cents lower? Two-fifths of the difference was goodwill amortization and one-time acquisition costs, such as fees for professionals. But three-fifths, or 7 cents a share, was classified as cost of sales in the 10-Q. The costs included laying off employees and writing down redundant inventories and assets to integrate the new operations. Investors wouldn't know those details just by reading the press release. If Flextronics had shown those expenses as costs of sales, it would have reported 19 cents a share, and the operating profit margin would have slipped to 3.8%, down from 4.2% a year earlier. Instead, the company said it achieved a 5% operating margin, its long-term goal. It was the third quarter in a row Flextronics took charges tied to acquisitions.

Thomas J. Smach, Flextronics vice-president for finance, says its reporting is fine. "I don't think our presentation is any different from most companies." The press releases are written for Wall Street analysts who disregard acquisition-related expenses, he says.

Flextronics CEO Michael E. Marks said in his January earnings conference that the silver lining in the tech downturn is that equipment makers will ask him to do more of their manufacturing. "The pipeline of opportunities for us is stronger than it has ever been, and our bias toward next year is increasingly positive," he said. The question is how long investors will keep handing Marks and his peers the money to do what his customers don't want to do themselves. By David Henry in New York

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