Contract Manufacturers: Coverage Revision at Bank of America Favors Flextronics, Benchmark

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Includes: BHE, CLS, FLEX, JBL, PLXS, SANM, SLR
by: Tiernan Ray

There’s been a changing of the guard over at Bank of America, with Jeff Walkenhorst taking over coverage of contract electronic manufacturers — also known as the “EMS” group — from Scott Craig, putting his own stamp on the stocks of Flextronics (NASDAQ:FLEX), Celestica (NYSE:CLS), Jabil Circuit (NYSE:JBL), Sanmina-SCI (NASDAQ:SANM), Plexus Corp. (NASDAQ:PLXS), Benchmark Electronics (NYSE:BHE) and Solectron (SLR). Whew.

So here’s his rundown of the group:

  • Jabil Circuit: He’s downgrading from Buy to Neutral, thinks the stock is worth $23, below its recent $23.49 price, rather than the bank’s prior target of $26. Basically, the company’s business is growing a lot slower as it has decided not to collect fees to assemble a large number of consumer goods because the profit margin on those goods is too slim, says Walkenhorst. Without aggressively going after high-volume new consumer applications, the company’s promises of 4% to 5% operating margins and greater than 20% return on invested capital are “a stretch,” says Walkenhorst. Jabil’s fiscal year ends in August, and for that fiscal period, Walkenhorst is lowering the Bank’s earnings estimate from $1.53 per share to $1.43, below consensus. The price target represents a valuation of 15x Walkenhorst’s estimate of $1.52 in profit per share for calendar ‘08.
  • Flextronics: Buy, it could go from around $11 a share now to $13, in part because the company’s intended acquisition of competitor Solectron, announced June 4, extends the company’s addressable market, and could add 5 cents to 2008 earnings per share if Flex can find $71 million in “synergies” in the deal. Flex has 50% of its employees in China, giving it the opportunity to compete effectively with Chinese manufacturers such as Hon Hai Precision (OTCPK:HNHAF). Walkenhorst raises his estimate for the company’s March-ending 2008 and 2009 fiscal years by a couple pennies apiece to $.95 and $1.13, and he says that at 10 times his estimate for the full calendar 2008 earnings, Flex is the cheapest stock in the EMS group.
  • Solectron: Neutral, as the company has been unable to grow revenue or improve profitability for years now, and there seems no reason to jump into the fray while it waits to be acquired by Flextronics (see above). His price target, $3.90, just a hair above Thursday’s price of $3.77, is 14x his estimate for calendar ‘08 earnings and is fair value assuming that Solectron does close the deal with Flextronics. If not, look out below.
  • Sanmina-SCI: Neutral, and his price target of $3.25 is just under Thursday’s share price of $3.26. What he doesn’t like is that the company is dumping its business that assembles personal computer products, which has low margins but a high return on invested capital. “Post sale, overall margins should increase, but ROIC should decline. Also, with the expected loss of a major customer, potential proceeds may not meet prior views. We consider ROIC the most important EMS metric.” Oh, and this is interesting: after moving 70% of its work force to “low cost areas,” as the euphemism goes, the company has yet to see much benefit from this “perpetual restructuring,” as Walkenhorst calls it, and he worries the company is going to just pass along 50% of the resultant cost savings to customers. Oh, well.
  • Benchmark Electronics: Buy, and his target price of $29 is above Thursday’s share price of $24.08. The company will have a better second half of the year than the first half, when it lost a whole chunk of business it had gotten from Sun Microsystems (NASDAQ:SUNW), which is finding a second source to split the work with. Sun’s still 25% of Benchmark’s revenue after this, and still an important customer. More important, Benchmark had a jump in bookings recently that could lead to increasing volumes of business, which Walkenhorst says is underappreciated by his peers. Look to the company’s earnings release on July 26 as a near-term catalyst for the stock. The stock is worth 15x a calendar 2008 earnings per share estimate of $1.94, writes Walkenhorst.
  • Plexus: Neutral, and the stock is worth just $24, below Thursday’s price of $24.96, says Walkenhorst, with the shares fairly valued despite a decent outlook for the company. On the negative side, sales growth is slowing to 6% this year from 19% last year. However, it’s a good company, says Walkenhorst, a “best-in-class” manufacturer focused on producing low-volume quantities of products with a high “mix,” meaning, a lot of different kinds of widgets. That leads to very high operating margins — highest in the group — at 5.5%, and the highest return on invested capital, at 17%. But it’s fairly valued at around $24, which is 17x his estimated $1.40 in eps for calendar 2008.
  • Lastly, Celestica: Neutral, because it’s just not clear when the company’s going to execute properly. “For six of the last eight quarters, Celestica’s organic growth was negative and operating margins were ~100 bps below the EMS industry average of 3.1%.” He assigns the stock a $6 price target, below Thursday’s $6.34.
  • There you have it. How are the stocks responding? They were all up except for Jabil and Celestica, which were down slightly, and Solectron, which was unchanged.