Can Contract Manufacturers Continue Their Strong Bull Run?

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Includes: BHE, CLS, FLEX, JBL, PLXS, QQQ
by: Vince Martin

Contract manufacturing is not an easy business. Revenues can be lumpy, as major projects skew quarter-to-quarter and year-to-year comparisons, making forecasting, staffing, and expense control more difficult. Gross margins in the industry are in the high single-digits; operating and net margins rarely exceed four percent. The business often requires a high concentration of revenue in a relatively small minority of major clients, limiting leverage in negotiations and creating downside risk for shareholders should the loss of a key customer be announced.

Recent headwinds haven't helped; the extraordinary weakness in the personal computer market, a slowdown in telecommunications equipment spending, and the overall drag of a below-expected economic recovery all have trickle-down effects to the manufacturers who make the circuit boards and components that drive most modern technology.

And yet, over the past few weeks, contract manufacturers have seen impressive spikes in their share prices:

JBL Chart
(Click to enlarge)

JBL data by YCharts

One-month chart of Jabil Circuit (NYSE:JBL), Sanmina Corporation (NASDAQ:SANM), Plexus (NASDAQ:PLXS), Benchmark Electronics (NYSE:BHE), Celestica (NYSE:CLS), Flextronics (NASDAQ:FLEX)

As a point of comparison, the Nasdaq 100 (NASDAQ:QQQ) is up less than 9 percent over the same period, showing the strong out-performance by the contract manufacturers.

The beginning of the run appears to coincide roughly with the release of March quarter results by the group:

CM Post-Earnings Gains, March Quarter

Stock Date* Gain (Loss)
CLS 4/23/13 5.6%
FLEX 5/1/13 (4.3%)
JBL 3/21/13 (4.5%)
SANM 4/23/13 15.3%
PLXS 4/18/13 0.3%
BHE 4/25/13 1.8%
Click to enlarge

* -- date of first trading session after earnings release; i.e., if earnings were released after the bell on 4/22, date is listed as 4/23

With the exception of Sanmina and Celestica, none of the companies posted exceptionally strong earnings. Yet in the weeks following those earnings reports came a bull run that has led the six stocks to gain an average of 18.8% over the past month -- double the gains of the Nasdaq 100, a tech-heavy index that includes many of these companies' key customers. And nearly all of the stocks are trading at mid- to long-term highs; both Benchmark and Sanmina trade at their highest levels in more than two years, while the other four companies haven't reached current share price levels in roughly 8-15 months.

The run-up in CMS shares is particularly surprising because not only were the earnings reports above expectations, they were largely subdued, showing some of the key challenges facing the industry. Among the lowlights (with a few highlights):

  • Celestica's first quarter revenue fell 19%, largely due to the loss of former key customer BlackBerry (NASDAQ:BBRY). But even excluding BlackBerry's departure, revenue was flat year-over-year. The midpoint of the company's second quarter guidance assumes an 18% drop in sales from the year-prior period. The company did say on its conference call that it expects improvements in revenue and margins in the second half, but earnings are still projected to fall year-over-year for the second consecutive year. (Note that the Reuters estimates are on a non-GAAP basis; non-GAAP EPS was $1.11 per share in 2011 and $0.89 in 2012. The company's substantial stock repurchase programs also mean the drop in non-GAAP net income is greater than the decline in non-GAAP EPS.)
  • In its fiscal year ending March 31, Flextronics saw revenue fall nearly 20 percent year-over-year, as it too lost BlackBerry as a customer. (BlackBerry accounted for more than 10 percent of sales in fiscal 2012, according to Reuters.) The midpoint of FQ1 guidance assumed a 10 percent drop in sales and a 39 percent decrease in adjusted earnings per share. Like Celestica, the company projected better days ahead; on the post-earnings conference call, CEO Mike McNamara argued that "we continue to believe that this past March quarter will mark our revenue and margin trough," boosted in part by the company's purchase of Motorola Mobility (now owned by Google (NASDAQ:GOOG)) operations in China. But non-GAAP EPS matched that of FY12, at 81 cents per share, with analysts projecting a modest decline in earnings on slightly higher revenue in FY14.
  • Jabil Circuit did post modest revenue gains, though earnings fell year-over-year in its fiscal second quarter. In the Q&A portion of its conference call, CEO Mark Mondello admitted that the company's previous guidance for full-year earnings growth of 5-10% had been too optimistic. "I think we'll be marginally down [from FY12]," he told an analyst, though he projected that earnings in FY14 and 15 would rebound sharply, creating three-year earnings growth of 7.5% annually on a compounded basis. Meanwhile, increased capital expenditures lowered the company's free cash flow guidance to $300 million from $500 million, with CFO Forbes Alexander admitting in the Q&A that much of the gains in operating cash flow would come from management of working capital.
  • Plexus's fiscal second quarter results showed modest year-over-year declines in virtually every key measure, with similar projections for FQ3.
  • Benchmark saw revenue and non-GAAP income fall in its first quarter; GAAP income gains came only as a result of the impact of the flooding in Thailand on 2012 Q1 results.
  • Even Sanmina, whose stock jumped 15 percent after its FQ2 earnings report, saw revenue fall in the first six months and guided for another modest decline in the June quarter. And while earnings rose sharply on a GAAP basis, that gain came largely due to sales of real estate; non-GAAP gross margin, operating margin, and operating profit all fell year-over-year.

With these types of near-term struggles, and the constant bemoaning of macro trends on nearly all the aforementioned conference calls, the recent strength in the stocks is somewhat surprising. The question becomes: is the market correctly anticipating a rebound in the industry -- essentially agreeing with Flextronics' McNamara that the industry is at or near the bottom -- or is this just a case of mostly high-beta stocks benefiting from an overheated market looking for value anywhere it can find it?

The latter is certainly possible, because even after the recent bull run, several industry companies have tempting fundamentals. JBL's Friday close of $20.05, even assuming a modest year-over-year earnings decline, is barely eight times its FY13 non-GAAP earnings. Flextronics has posted $2.7 billion in free cash flow over the past five years, relative to a $4.8 billion market cap. Sanmina's forward P/E sits at 8.6, according to finviz.com, while Celestica trades at less than six times FY14 projected earnings, after backing out its substantial cash balance.

The question is whether these fundamentals represent hidden gems, or whether they are reflective of the economic and structural challenges facing the industry. Given the competitive nature of contract manufacturing, its low margins, and its reliance on key customers, it's not an industry that will likely receive -- or deserve -- outsized multiples. And with continued economic headwinds, and a continued emphasis on cost-cutting and streamlining across corporate America, the leverage that contract manufacturers hold over their customers continues to decrease. Many of the CMs themselves -- notably Sanmina and Flextronics -- have taken restructuring charges of late, as they right-size in the wake of customer defections and/or revenue declines. All the companies in the sector are making clear their efforts to control costs and expand margins; and when operating margins are only 2.5-3.5%, even a 10 or 20 basis point improvement can have real effect on the bottom line.

The problem is that contract manufacturing customers are doing the exact same thing, putting top-line pressure on their outsourcing partners. So as companies like Benchmark and Sanmina publicly tout operating margin targets, actually reaching those targets may be easier said than done.

Over the next few weeks, I plan to review in more detail some of the specific stocks in the sector, and their potential suitability for investors. In the near term, the sector is an interesting place for traders to look. Those traders betting on the broad market, and particularly techs, pulling back after reaching decade-long highs can look to short names in the CM space. The stocks are high-beta and susceptible to being hit hard by any fears of a tech spending slowdown; given their recent run-up, a small dip could be accelerated by profit-taking from shareholders eager to protect short-term gains. Conversely, bullish traders can use the higher volatility and often higher leverage in the sector to see bigger gains if the Nasdaq continues to move higher (as has happened over the last month).

For longer-term investors, the space has a bit of a "wait and see" feel to it. There has been a lot of movement in share prices; but not much movement in terms of news or growth. If the last quarter was indeed a trough for the industry, it seems likely that there will still be time for investors to join in the rally. If it was not -- if macro headwinds and the inherent challenges of a business with such razor-thin margins prove too much for the sector -- the mid- to long-term highs CM stocks reached this week will be just a memory, very quickly.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.