Weathering the Storm
By Jim Corridore
Flextronics International (FLEX ), one of the largest and fastest growing companies in the electronic manufacturing services (EMS) industry, is weathering the slowdown in information technology spending better than most of its competitors. Given its recent deals with Ericsson and Motorola, and its correct positioning in the low cost area of the business, the company was one of the few tech companies that did not issue an earnings warning during the March quarter. When Flextronics reported fourth quarter (ending March) results on April 24, the company missed the consensus street EPS target by two cents, but EPS increased 29% (excluding goodwill amortization and restructuring charges) on 40% revenue growth during a tough quarter.
We feel that is a pretty impressive performance in light of the current environment. Indeed, Flextronics shares have fallen 44% from its 52-week high, and through April 25, were down 14% year-to-date. After the earnings report, we upgraded the stock to an accumulate (S&P 4 STARS ranking) from hold (S&P 3 STARS ranking).
Flextronics is the world's second largest provider of manufacturing and assembly services for original equipment manufacturers (OEMs) in the telecom and networking, consumer electronics and computer industries. Flextronics provides design services, manufacturing services including the fabrication and assembly of plastic and metal enclosures, printed circuit boards and backplanes, and logistics services such as materials procurement, inventory management, packaging and distribution. Customers include industry leaders such as Cisco, Ericsson, Hewlett-Packard, Lucent, Microsoft, Motorola, Nokia, Palm Computing and Philips.
In some cases after designing a new product (often with Flextronics' help), an OEM will never again see that product. Flextronics takes an order for a product, builds it from parts acquired from their suppliers, and then ships the finished product directly to the end-user with the OEM's name on it. This can be a very attractive value proposition for OEMs, since it allows them to focus their limited resources on R&D and marketing, while getting a lower total cost for manufacturing due to the large economies of scale, lower cost component purchasing, and Flextronics' state of the art technology.
This outsourcing model, along with strong demand for technology products including mobile phones, PCs and networking products, sparked very fast growth for the overall EMS industry through last year. Over the past decade, OEMs have continued to increase the percentage of their products that they outsource, and in the last couple of years OEMs have stepped up the sale of manufacturing assets to EMS companies, who take over the production at those plants.
TIMES HAVE CHANGED. The EMS sector is now feeling the pain of the entire technology sector in response to the economic slowdown and subsequent decrease in IT spending growth. Most of the top tier EMS providers, after steadfastly insisting that in an economic downturn OEMs will outsource more rather than less, have finally admitted that the severity of the current slowdown will hurt them too. Industry growth, which had been targeted at 25% plus annually, has temporarily slowed to a crawl.
Flextronics is holding up better than most of its competitors partly because the majority of its facilities are located in low cost areas like Eastern Europe, Asia and Mexico. This enables the company to produce at a lower total cost than its competitors, which is something that OEMs are very interested in.
Plus, during the current slowdown there has been an increased emphasis on higher volume products -- something that Flextronics excels at. One of Flextronics' recent deals is with Ericsson. Beginning in the current quarter, Flextronics will take over the manufacturing of virtually all of Ericsson's cellular telephones. However, since Ericsson has been hit by a slowdown, investors have not focused on the large incremental revenue opportunity this deal provides to FLEX. Investors have also been spooked by an agreement for Sony and Ericsson to form a joint venture, but Sony has only limited cellphone manufacturing operations, which should not be a hindrance to a large ramp of cellphone manufacturing by Flextronics.
In May 2000, Flextronics formed a strategic alliance with Motorola that provides incentives for Motorola to purchase $30 billion in products and services from the company through 2005. Motorola paid $100 million in exchange for an equity investment that entitles Motorola to acquire 11.0 million FLEX shares. However, many investors are not fully aware that Motorola must meet targeted purchase levels in order to get the equity investment.
GROWTH INTACT. Looking to the June quarter, Flextronics sees flat sequential revenue and EPS, which still equates to about 16% top and bottom line growth from a year ago, amid one of the harshest demand corrections in recent memory. We forecast about 20% revenue growth in FY 02, as the benefits of the Ericsson deal start to kick in and as demand improves in the second half of the fiscal year. The company has completed a restructuring program that effectively cut manufacturing capacity by 15%, primarily at higher cost locations, and reduced headcount by 10%. This should boost margins in FY 02, leading to our $1.15 EPS target, which would represent 32% growth over FY 01.
Flextronics' stock price has already corrected to reflect dimmer near term prospects in the industry. The shares are currently trading at about 21 times our FY 02 EPS target, well below our expectations for more than 30% compound annual EPS growth over the next 5 years. The current P/E is at the low end of the company's historical P/E range. In addition, there is increased potential for industry consolidation or continued OEM asset divestitures in the current environment, which could lead to acceleration in revenue and earnings growth beyond our current targets.
Jim Corridore is a technology industry analyst at Standard & Poor's