Two Outstanding Outsourcing Picks

Prospects for contract manufacturers remains bright -- especially for industry heavyweights Celestica and Flextronics

By Richard Stice

Investors scanning the technology landscape for potential bargains should take a look at the contract manufacturing services group. Despite a recent run-up in price, many of these companies are still down sharply from their all-time highs. However, the future outlook for this sector remains bright.

A recent survey conducted by Bear Stearns indicated that 85% of original equipment manufacturers (OEMs) expected to increase their use of contract manufacturing services over the next twelve months. Moreover, in the long run, OEMs are expected to outsource 70% or more of their manufacturing functions, a far cry from the current penetration rate of approximately 13%.

It's clear that this market segment has enormous potential. In today's economic environment, OEMs are ever more vigilant in cutting costs and increasing efficiencies. One of the easiest and most profitable ways to meet these two objectives is to outsource portions of the manufacturing process. The resulting benefit to OEMs is a renewed focus on product development and a more effective allocation of capital.

However, there is a caveat to this market trend: size matters. Many OEMs have decided to limit the quantity of contract manufacturers that they will work with going forward. For instance, Hewlett-Packard has announced plans to scale back the number of its contract manufacturing partners to four, from an earlier total of twenty.

The end result is that companies with a broader array of capabilities, encompassing manufacturing, logistics and supply chain services will be the ultimate beneficiaries of this progression. Conversely, the smaller players, in terms of market share, are likely to be squeezed out as they are less capable of providing the same level of service while remaining cost competitive.

And so, S&P favors the larger-tier players in the group, especially Celestica (CLS ) and Flextronics (FLEX ).

Celestica: Originally a manufacturing unit of IBM, Celestica offers a wide variety of services to OEM customers, including the manufacture, assembly and test of complex printed circuit board assemblies, and full system assembly of final products. The company targets industry-leading OEMs primarily in the computer and communications sectors, including Cisco, Dell, EMC, Hewlett-Packard, IBM, and Sun Microsystems. Its facilities are organized as customer-focused factories, with dedicated manufacturing lines and customer teams.

The shares of Celestica have recovered somewhat in recent weeks, though they remain more than 50% below their 52-week high due to the lingering economic slowdown. Despite the lackluster performance, we at S&P believe the company's low-cost manufacturing capabilities and diversified business mix provide it with competitive advantages.

We are targeting 15% revenue growth in 2002, and cash earnings per share of $1.80. Trading at approximately 19 times our 2002 EPS estimate, with a p-e-to-growth ratio of 0.70, both at discounts to its peers and the broader market, Celestica (ranked 4 STARS, or accumulate) offers uncommon value in a challenging market environment.

Flextronics: Through a combination of internal growth and acquisitions, Flextronics International has become one of the world's largest contract manufacturers. The company provides services to OEMs in the telecom, networking, computer, consumer electronics and medical industries. Services range from initial product design, to volume production and fulfillment. It also provides logistics services, including materials procurement, inventory management, packaging and distribution.

Even with recent improvement in the performance of its shares, Flextronics remains well below its high water mark. However, there are some positive catalysts on the horizon. First, Flextronics is the North American manufacturer of consoles for Microsoft's much-anticipated X-Box video game, which is expected to be released in mid-November. We expect the publicity surrounding the launch, combined with favorable previews of the product, will result in the contract being an important contributor to bottom line results.

Second, the company has recently made a strategic decision to consolidate its manufacturing operations in low-cost regions of the world, including Brazil, the Czech Republic, Hungary, Mexico and Poland. We believe this fundamental shift will further strengthen Flextronics' position as the low-cost industry producer. Finally, Flextronics, along with the other large-tier companies in this sector, should see more opportunities for manufacturing as the outsourcing trend continues to move forward.

We are forecasting revenue growth of 12% in fiscal 2002 (ending March), and cash EPS of $0.65, followed by a greater than 30% rise in fiscal 2003, and cash EPS of $1.00. Based on our fiscal 2003 EPS estimate, the shares trade at a discount to their peers on a p-e and p-e-to-growth basis. We believe the valuation, along with new market opportunities via the X-Box relationship, and the realigning of its operations, make Flextronics (ranked 4 STARS, or accumulate) a compelling investment in the midst of a difficult economic climate.

Stice is a technology analyst covering contract manufacturing services stocks for Standard & Poor's

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