Solectron's Losing Battle

The electronic manufacturing service industry is looking ugly. Competition is intense, margins are razor-thin, and customers are increasingly demanding. The pressure tends to magnify any small glitches in operations, inevitably ruining a CEO's day. Take Solectron's (NYSE: SLR  ) CEO Mike Cannon, for example; he was grilled by analysts regarding the company's disappointing first-quarter earnings report.

Things got off on the right foot this past quarter. Revenues were up 3% sequentially and 22% year over year. That same period saw growth in all segments except Automotive. Solectron increased its dealings with Sun Microsystems (Nasdaq: SUNW  ) , and business in the Networking segment, where Cisco Systems (Nasdaq: CSCO  ) accounts for 19% of total revenue, was up 25% year over year.

Even though revenues are on track for fiscal 2007, there was significant disappointment on the profitability side -- hence analysts' consternation on the conference call. Gross margins dropped 30 basis points sequentially, to 5.1%. The margin slide was mainly due to operational difficulties in Solectron's service business, but some of it was attributed to a shift in revenues to lower-margin products. Similar margin drops don't usually generate such angst, but remember, Solectron is already operating at profitability levels significantly below its cost of capital.

Management is fully aware of this, which makes the margin slide even more disappointing. At the November investor's conference, management presented profitability targets of 7%-8% in gross margins, and EBIT (earnings before interest and taxes) of 4%, for a resulting ROIC of 15%. Only Jabil Circuit (NYSE: JBL  ) currently achieves this level of profitability, and until Solectron can also reach these levels, I'm afraid its conference calls will become even more contentious.

But what if management can achieve its profitability targets? Using back-of-the-envelope math, if Solectron generated 4% operating margins on an estimated $11.5 billion in revenues, fiscal 2007 earnings could be $0.48 per diluted share. At its current P/E of 15, that would price the stock at $7.20 per share, higher than yesterday's close of $3.20.

However, this is just playing with numbers. I have little confidence that Solectron's desired margins will materialize until it has less competition and greater pricing power. While I am impressed with the CEO's candidness in handling the tough questions and his overall awareness of the situation, that's not enough for me to recommend the stock to Foolish investors.

We've chipped in with further Foolishness:

Fool contributor Matthew Crews welcomes your feedback -- really! He does not have a financial position in any of the companies mentioned. The Motley Fool has a disclosure policy.


Read/Post Comments (0) | Recommend This Article (201)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 518919, ~/Articles/ArticleHandler.aspx, 10/21/2014 10:16:23 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement