Flextronics Adds a Key Part

The electronic manufacturing services outfit buys rival Solectron to bolster its position in a tough industry

If you can't beat 'em, merge 'em. In a tough industry with depressed stock prices, leading electronics manufacturing services (EMS) provider Flextronics International (FLEX) announced on June 4 it will acquire smaller competitor Solectron (SLR) in a $3.6 billion deal. Both companies design and make computers, networking gear, cell phones, and other products that technology companies sell. EMS players have been struggling with tepid capital spending on technology, as well as pricing pressures and stiff competition from Asian players (see BusinessWeek.com, 5/30/07, "EMS: Victims of Wait-and-See Spending").

Solectron shares, which have been wallowing in a narrow range of $2.81 to $3.67 for the last year, jumped 14.5% to $3.86 in huge volume on the NYSE on the news. Flextronics shares lost 1.6% to $11.51 on the Nasdaq on June 4. Flextronics shares have ranged from $13.26 to $9.62 over the past 52 weeks.

Under terms of the agreement, Solectron shareholders can convert each share into 0.3450 shares of Flextronics or get $3.89 per share in cash (but not a combination). Only 50-70% of Solectron shares are allowed to be converted to Flextronics shares. The buyout is expected to close by the end of the year with the approval of shareholders and regulators.

The cash bid is a premium of about 15% above Solectron's closing price of $3.37 on Friday, June 1, while the stock portion represents a 20% premium based on Flextronics' closing price on Friday.

Flextronics said the deal will help it compete and "enhance its ability to design, build, and ship a complete package product for its customers."

"Solectron is an extremely important strategic addition to Flextronics and this combination transforms the landscape of our industry," said Mike McNamara, CEO of Flextronics, in a press release. "Solectron's strength in the high-end computing and telecom segments will be an invaluable addition to Flextronics's existing capabilities and the combined company will be a market leader in most product market segments."

McNamara added: "The combined company is clearly more diversified and formidable than either on its own, and we are better positioned to increase shareholder value through greater cash flow and earnings." The company figures it could take up to 18-24 months to integrate Solectron and realize the full synergy potential, which it pegs at least $200 million after-tax and add 15% to Flextronics' earnings per share.

Some analysts think the combination makes sense. "A $30 billion-plus company has the size and wherewithall to compete," said Standard & Poor's analyst Jawahar Hingorani in an interview. "Flextronics has a good history of execution and it will bring that to Solectron."

Flextronics gains competitive advantage in its industry, he says, but he'll be monitoring the integration of this large acquisition. "In our view, synergies related to the acquisition will not be EPS-accretive for over 12 months, but we believe the transaction could be cash-flow positive before that," he said in a note.

Hingorani kept his buy recommendation on Flextronics shares and his 12-month target price at $14, which amounts to 15 times his fiscal year 2008 (ending March) earnings per share estimate of 94 cents -- a p-e that's above peers, he says.

Flextronics makes handheld devices, set top boxes, home appliances, communications infrastructure, servers, navigation instruments, and diagnostic equipment. Its largest customers include Sony-Ericsson, Motorola (MOT), and Hewlett-Packard (HPQ). In fiscal year 2007 (ended Mar. 31), its revenue rose 23% from the prior year to $18.854 billion.

Meanwhile, Solectron has been struggling. Solectron's revenues rose just 1.1% in fiscal year 2006 (ending Aug. 31) to $10.561 billion, after dropping in the prior year.

The company was cash flow negative in fiscal year 2006, after free cash flow exceeded $850 million in fiscal year 2005, notes S&P. It has been trying to improve its operations by restructuring. On Oct. 2, 2006, Solectron said that in its fiscal year 2007, it would close or consolidate around 700,000 square feet of facilities in Western Europe and North America, and cut 1,400 jobs -- which could save it $35-$40 million a year. The company anticipates total charges of $50-$60 million in fiscal year 2007 as a result of the restructuring.

And in February, Solectron's CEO Michael Cannon left to become Dell's (DELL) president of global operations. Solectron's chief financial officer, Paul Tufano, was named interim CEO.

Some of Solectron's biggest customers include Cisco Systems (CSCO), Hewlett-Packard, and Nortel Networks (NT). S&P's Hingorani says in a research report that Solectron, like many of its peers, has been expanding from making computer and telecom gear into other areas -- such as automotive, aerospace and defense, industrial and medical -- to stimulate growth. Examples of products offered by Solectron are audio and navigation systems, wafer fabrication equipment tools and X-ray equipment, he says.

Hingorani kept his hold opinion on Solectron shares on June 4. "We think synergies and savings won't be meaningful until second half of 2008," he said in a note. "We see near-term cash charges offset by cash flows from combined operations." He lifted his target price by $0.50 to $4 to reflect the deal premium, which values Solectron shares at about 0.3 times his calendar 2007 revenue per share estimate, in line with their historical average.

Morningstar analyst Andrew Golomb thinks the offer is too low for Solectron shareholders, given his $5 fair value estimate on the stock. Still, the acquisition makes sense strategically, he says. Flextronics will benefit from Solectron's high-end manufacturing capabilities in the telecom and enterprise sectors, as well as warranty-repair services, while Solectron will get Flextronics' "industry-leading inventory management skills," he says. Plus, Golomb says: "Industry consolidation is a step in the right direction for reducing excess manufacturing capacity."

Still, he's concerned that the tough industry dynamics could get in the way of the deal's benefits. He doesn't think pricing pressures will ease anytime soon, given that it will take time to eliminate excess capacity in the industry. And he says there's risk that customers may diversify their outsourcing needs to a competing EMS firm, which could hinder Flextronics' ability to boost Solectron's operating margins.

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