By Richard Stice, CFA We have a positive outlook on the Electronic Manufacturing Services (EMS) subindustry, despite its continued underperformance relative to the major indices. Through June 3, this group posted a year-to-date decline of 12.4%, which follows a 14.5% drop in 2004. This compares with the Standard & Poor's 500-stock index's 1.3% decline and 9.0% gain over the same time periods.
Our positive opinion stems from our belief that the overall outsourcing trend continues to gain traction and is being embraced by a growing number or organizations searching for additional ways to reduce their manufacturing costs.
DIVERSIFIED REVENUE. Moreover, many EMS companies are benefiting, in our view, from a focus on revamping their business mixes and cost structures, which includes devoting more resources to design-based projects and shifting production facilities to lower-cost areas such as Asia and Latin America. These actions have resulted in higher capacity utilization rates and improved margins.
Another beneficial development is the industry's transition to a more diversified revenue base. Previously underserved markets such as the automotive, industrial, and medical sectors offer potential new avenues of growth, which we think will help reduce the intensity of seasonal impacts and improve profitability.
From a valuation perspective, the EMS companies that we follow trade at an average price-to-sales of 0.5, and a p-e-to-growth rate below 1.0. We believe these ratios are normally consistent with more slower-growing and mature industries. These values are not only far below the peaks experienced during the "bubble era" of technology stocks, but in our view do not adequately reflect the industry's current and future growth opportunities.
TALENT ON TAP. Looking ahead, we think that larger industry players will win a disproportionate share of outsourcing contracts. We believe customers are trying to limit the number of providers with whom they do business, in an attempt to streamline their outsourcing practices. As a result, we see the larger and more established EMS participants taking share from their smaller competitors, as they should be better able to satisfy customer requests given their breadth of services.
The largest EMS company based on revenues is Flextronics International (FLEX
; ranked 4 STARS, or buy; recent price: $13). The company recently disclosed some noteworthy events that we think will benefit its stock performance.
First, Flextronics' long-time CEO, Michael Marks, announced he will step down in January and assume the role of chairman of the board. Michael McNamara, who has held senior-level positions at the company for over ten years and is currently chief operating officer, will replace him. While we're somewhat disappointed to see Marks step down, we view the timing of this move as prudent and think McNamara is well qualified for the role.
NORTEL DEAL. Second, in keeping with its new strategy to divest or spin-off non-core businesses, Flextronics reached an agreement with Telavie A/S to merge its wholly-owned network services subsidiary. Further, the company acknowledged that it has talked with a number of interested parties about the potential sale of its semiconductor design operations.
If both deals are consummated, Flextronics would receive an estimated $550 million to $600 million, plus additional contingent payments, along with a 30% ownership stake in the merged network services business. We believe these actions will give the company additional financial flexibility and allow more resources to be allocated for key business initiatives.
Another catalyst that should aid future profitability is a manufacturing agreement with Nortel Networks (NT
; ranked 3 STARS, or hold; $3). After originally being struck in 2004, the deal is expected to boost Flextronics' revenue sizably in its 2006 fiscal year (ending March). Flextronics believes the arrangement will add $1 billion to revenues in fiscal 2006 and $2 billion in fiscal 2007, up from less than $100 million contributed to revenues in fiscal 2005.
THREE BIG POSITIVES. We are forecasting total revenues of $17.2 billion in fiscal 2006, a gain of 8% from the prior year, and operating earnings per share of 82 cents, an increase of 24% from fiscal 2005's 66 cents. Our 12-month target price for the shares is $15. This target price is derived via a combination of discounted cash flow analysis and a relative price-to-sales measure.
Given what we see as an advantageous industry position, extensive network of services, experienced leadership team, and attractive valuation, we advise purchase of Flextronics' shares.
Risks to our recommendation and target price include a slowdown in demand for electronics products, loss of market share, the implementation of additional restructuring efforts beyond those currently disclosed, and integration risk associated with the assets of Nortel Networks.
In the U.S.
As of March 31, 2005, research analysts at Standard & Poor's Equity Research Services U.S. have recommended 30.8% of issuers with buy recommendations, 56.7% with hold recommendations and 12.5% with sell recommendations.
As of March 31, 2005, research analysts at Standard & Poor's Equity Research Services Europe have recommended 29.2% of issuers with buy recommendations, 50.5% with hold recommendations and 20.3% with sell recommendations.
As of March 31, 2005, research analysts at Standard & Poor's Equity Research Services Asia have recommended 34.3% of issuers with buy recommendations, 48.0% with hold recommendations and 17.7% with sell recommendations.
As of March 31, 2005, research analysts at Standard & Poor's Equity Research Services globally have recommended 31.0% of issuers with buy recommendations, 55.2% with hold recommendations and 13.8% with sell recommendations.
5-STARS (Strong Buy): Total return is expected to outperform the total return of a relevant benchmark, by a wide margin over the coming 12 months, with shares rising in price on an absolute basis.
4-STARS (Buy): Total return is expected to outperform the total return of a relevant benchmark over the coming 12 months, with shares rising in price on an absolute basis.
3-STARS (Hold): Total return is expected to closely approximate the total return of a relevant benchmark over the coming 12 months, with shares generally rising in price on an absolute basis.
2-STARS (Sell): Total return is expected to underperform the total return of a relevant benchmark over the coming 12 months, and the share price is not anticipated to show a gain.
1-STARS (Strong Sell): Total return is expected to underperform the total return of a relevant benchmark by a wide margin over the coming 12 months, with shares falling in price on an absolute basis.
Relevant benchmarks: in the U.S. the relevant benchmark is the S&P 500 Index, in Europe the S&P Europe 350 Index and in Asia the S&P Asia 50 Index.
For All Regions:
All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.
Additional information is available upon request.
This report has been prepared and issued by Standard & Poor's and/or one of its affiliates. In the United States, research reports are prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"). In the United States, research reports are issued by Standard & Poor's ("S&P"), in the United Kingdom by Standard & Poor's LLC ("S&P LLC"), which is authorized and regulated by the Financial Services Authority; in Hong Kong by Standard & Poor's LLC which is regulated by the Hong Kong Securities Futures Commission, in Singapore by Standard & Poor's LLC, which is regulated by the Monetary Authority of Singapore; in Japan by Standard & Poor's LLC, which is regulated by the Kanto Financial Bureau; and in Sweden by Standard & Poor's AB ("S&P AB").
The research and analytical services performed by SPIAS, S&P LLC and S&P AB are each conducted separately from any other analytical activity of Standard & Poor's.
S&P and/or one of its affiliates has performed services for and received compensation from FLEX and NT during the past 12 months.
This material is based upon information that we consider to be reliable, but neither S&P nor its affiliates warrant its completeness, accuracy or adequacy and it should not be relied upon as such. With respect to reports issued by S&P LLC-Japan and in the case of inconsistencies between the English and Japanese version of a report, the English version prevails. Neither S&P LLC nor S&P guarantees the accuracy of the translation. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Neither S&P nor its affiliates are responsible for any errors or omissions or for results obtained from the use of this information. Past performance is not necessarily indicative of future results. Analyst Stice follows electronic manufacturing services stocks for Standard & Poor's Equity Research