Benchmark Electronics: Probing at Value

Benchmark Electronics (BHE) was mentioned as a buy idea by a value fund manager last week on CNBC. This article will provide a general analysis of the stock.

Benchmark is a contract manufacturing company. This industry provides outsourced manufacturing and logistics for many large technology companies such as Hewlett Packard (HPQ), Cisco (CSCO), etc. BHE's two largest customers are Sun Micro (JAVA) and EMC (EMC).

The industry itself is on the minus side of mediocre in terms of financial appeal. Margins are low, leading to sub-par returns on investment. Success is dependent on the growth of the customer as well as ability to retain existing contracts. Manufacturing expertise is high, but intellectual capital seems minimal. Existing factories plus service and quality excellence may provide some barriers to entry. In addition to BHE, the better companies in this industry have historically been Jabil (JBL) and Flextronics (FLEX).

BHE has shown increasing revenues and profits over the years, meriting a label of "cyclical growth." More recently acquisitions have become more important. The business mix is less diversified then I would prefer, with over around 50% of revenues linked to the computer industry.

Management guided to 15 – 20% eps growth for 2008, which produces an estimate of $1.50 +/-. With the stock at $17.30, the implied P/E multiple on '08 is 11.5X. Other valuation metrics are similarly attractive, with price to book 0.94, price to revenues 0.42 and enterprise value to EBITDA 6.6X

Some further analysis is required before concluding this represents a favorable buy point. In particular, the company's tax rate is very low at 14%, owing to tax concessions granted by foreign governments to locate plants in their countries. According to BHE, these tax breaks expire at various times through 2012. That is not very far off, and students of Ben Graham's security evaluation methods will recall that he recommended normalizing benefits of this nature when the expected duration was relatively finite. When I did this computation on 2007 results, I calculated a 6.5% return on total capital, 6.5% return on equity, and 10.1% cash flow return on investment for BHE. These types of returns confirm that BHE's business is mediocre to inferior in terms of investment attraction.

Looking to 2008, the P/E is 15.1X if we normalize the tax rate in similar fashion. CAPX per management guidance will approximate depreciation this year, so excluding any working capital impacts, free cash flow is essentially equal to net income. Thus the free cash flow yield is 8.7% on reported earnings, which is good but not compelling given the nature of the business. And normalizing the FCF yield for the low tax rate produces 6.6%, which again is OK but not an urgent buy signal. I would be more interested in the stock were it to come in a little to the $14 – 15 range.

BHE does not pay a dividend but last year began to buy in stock under a $125MM repurchase. That program is nearly complete. The 2007 purchases were done at an average of $20.33 per share, while the Q1 2008 repos were accomplished at an average price of $16.66. Regarding stock options, the weighted average exercise price at 3/31/08 was $19.15 per share (vested and unvested.) So at this time, both the options as well as a good bit of the shares repurchased are modestly under water. This would, all else equal, tend to focus management's attention on ways to get the stock price up. The company is coy about expanding the share repurchase program beyond the existing amount. Acquisitions are also on the agenda, and there is some balance sheet cash hung up in the now-familiar auction rate securities, so keeping flexibility open is likely a priority.

On the last conference call, management was questioned diligently about maintaining full year guidance despite missing on the top line for Q1, as well as the clearly deteriorating macro environment (recall, about 2 weeks before BHE reported we had the GE Black Friday earnings miss which was a shock to most investors.) BHE says they are confident in the guidance because it is driven by new program ramps baked in to the rest of the year and into '09, a better mix of business, and the impact of cost takeouts already done.

On the balance sheet, BHE fortunately has minimal debt and a substantial, albeit somewhat liquidity impaired, cash position. In addition, there are significant long lived tax NOL's which I discount by a third to adjust to present value and count at $1.58 per share.

Recapping Q1 earnings, management called it in line on eps but technically I think it was a penny miss, and definitely a miss on the top line, which was attributed to a lack of pull through at the very end of the quarter (sounds a lot like what GE said about their miss.) Eps were down only 3% yr/yr, at 0.33 vs. 0.34, but the path there was sloppy: Revenues down 9%. Gross margins down 63 bps to 6.61%. Aiding the comp was an absence of restructuring charges vs. last year, 4.2 cents, a positive swing in "other" income, 2 cents, a positive swing in net interest income, 2.5 cents, and fewer shares outstanding due to the buyback, 3 cents.

Overall, I come out less than enthused about BHE. The positives are: revenue visibility is OK absent a blowup from one of their customers, the big run off in Sun Micro revenues has pretty much run its course, the company is winning significant new business which will add to visibility in 2009, the stock price has retreated quite a bit, and the valuation at least on a superficial basis is decent. That said, when buying a mediocre business model, valuation should be compelling, not just "OK". And I do not see any catalyst for the stock. If everything else in the market were fair to expensive, BHE might look more interesting as a relative trade. But with the current correction having produced many oversold stocks, some of which are truly good business models at the best valuations in five years, BHE looks more like a stock which will move more/less in line with its sector and the overall market.

Disclosure: None