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Flextronics Flexes Its Muscle

By Richard Stice, CFA Following a difficult three-year period that included a protracted slowdown in revenue and earnings-per-share growth, painstaking restructuring efforts, and reductions in headcount, the electronics manufacturing services (EMS) industry has emerged much leaner and more proactive. In Standard & Poor's opinion, this successful transformation is attributable to the industry's astuteness in relocating production to lower-cost regions, expanding its service offerings, and diversifying its customer base.

Today, most of the major EMS providers manufacture the bulk of their products in places like Asia, Eastern Europe, and Latin America. Moreover, the EMS group has embraced the budding design-related market as a way to augment growth prospects and improve margin performance. Finally, after being burned by drastic reductions in telecom infrastructure spending, EMS companies have branched out into other vertical markets including the automotive, industrial, and medical segments.

Research firm International Data Corp. forecasts total EMS revenue in 2004 of $103 billion, an increase of 11% from 2003's $93 billion. In addition, IDC expects revenues to reach $150 billion by 2007, which corresponds to a compound annual growth rate of 12.7% from 2003 to 2007. We believe the industry is poised to benefit from the growing outsourcing trend, which allows customers to realize the dual benefit of reducing costs while simultaneously devoting more resources to various strategic initiatives.

TRENDSETTER. As a result of all of these factors, we have a positive view of the industry. Our top pick in the group is Flextronics International (FLEX

; ranked 5 STARS, or buy). In our opinion, Flextronics has done an excellent job of lowering costs and embracing new avenues for growth. The Singapore-based company was one of the first in the industry to enact a plan to move its manufacturing production to lower-cost area and now produces nearly half of its revenues in Asia.

We also believe Flextronics has an advantageous industry position because it's the largest EMS provider in terms of revenue. According to IDC data, Flextronics' total market share was 15.4% at the end of 2003, which is 3.5 percentage points above its nearest competitor. Moreover, to lower costs and improve overall efficiency, many customers are reducing the number of EMS providers they work with. We think this is a major benefit for larger industry players like Flextronics, as smaller competitors won't likely be able to offer the same breadth of services.

In terms of business mix, Flextronics has been active in the development of its design-manufacturing segment. This area turned a profit during the December quarter, with most of the business revolving around the wireless handset market. We anticipate this sector achieving revenue totals of between $300 million and $500 million during 2004.

This strategy is particularly beneficial to Flextronics' overall profitability as gross margins related to this type of work are typically in the low- to mid-double-digit range, which is well above the 5.8% Flextronics reported in its most recent quarter.

BETTER MARGINS. Flextronics has also gravitated away from telecom infrastructure over the last couple of years in an attempt to broaden its revenue base. In less than two years, its revenue from this market declined to 14% of the overall total, from 18%. Conversely, the company increased its exposure to the computer/office-automation segment, to 25% from 15% of total revenue, and the industrial/medical markets, which rose to 9% from 6%.

For fiscal 2005 (ending March), we anticipate revenue growth of approximately 12%, to $16 billion, boosted by the expanding outsourcing market and benefits associated with Flextronics' growing service capabilities. We expect gross margins to approach 6% as a result of higher volumes and a more favorable business mix. We forecast fiscal 2005 operating EPS of 60 cents, a 50% jump from fiscal 2004's estimated 40 cents.

The shares, which traded around $18.40 on Mar. 4, are attractive on a valuation basis, in our opinion. Our 12-month target price is based on a combination of discounted cash flow (DCF) analysis and a relative price-to-sales metric. Our DCF assumptions include a weighted average cost of capital of 11.3%, a peak growth rate of 24% in year five, and an expected terminal growth rate of 3%. These inputs result in our estimated intrinsic value calculation of $26.20.

On a price-to-sales basis, Flextronics trades at a discount to its historical average of 0.81. Applying this historical ratio to our calendar 2004 sales projection implies a share price of $22.50. Combining our DCF and price-to-sales values leads to a 12-month target price of $24. Given our view of Flextronics' better financial leverage, industry-leading market position, more favorable business mix, and attractive valuation, we advise that investors purchase the shares.

Note: Richard Stice has no stock ownership or financial interest in any of the companies in his coverage area. He's a registered representative of Standard & Poor's Securities, Inc. Other S&P affiliates may provide services to the companies under discussion. Analyst Stice follows electronics manufacturing services stocks for Standard & Poor's Equity Research

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