Who really turns sand into silicon? Electronic manufacturing services companies make everything from cell phones to personal digital assistants to optical routers. So who are they and what are their prospects? Research Fool Todd Lebor looks beyond the brands to uncover some investment opportunities.
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My hobby causes me to turn cereal boxes upside down in search of the manufacturer, and to read candy wrappers to find out who is responsible for the tasty treat inside. Warren Buffet is famous for practicing and preaching that people should invest in what they know and understand. Heck, it's one of the underlying principals to the Rule Maker Portfolio. Sometimes the simplest observations lead to the most brilliant investments.
In fact, that is what Foolish Research is all about. We're not here just to enrich and amuse, but also to educate. Educating common investors to be able to make their own informed investment decisions. Decisions like what sectors to look at and what companies to look at in the promising sectors. We supply the clay. You do the sculpting.
Enough propaganda. Back to infrastructure.
Thanks to powerful branding campaigns by Intel (Nasdaq: INTC) and Cisco Systems (Nasdaq: CSCO), average Americans now know who provides computer chips and routers, but few people know who really makes these devices.
In the new economy, electronic manufacturing services (EMS) companies are often making the components rather than the original equipment manufacturers (OEMs). Companies like Cisco and Motorola (NYSE: MOT) are farming out manufacturing to EMS companies at dizzying levels. A greater percentage of the components that go into everything from cell phones to personal digital assistants to optical routers are being made by these no-name companies.
A case in point is Cisco. All of its printed circuit boards are built by EMS companies and more than 50% of its assembly work is done by EMS companies. As Fool researcher Phil Weiss stated in his initial report on Cisco, Cisco "never even touches 55%" of its orders.
The concept is an old one. For decades now, auto makers have been relying on parts from hundreds of smaller auto parts companies. This is no different, except that the auto industry is not growing at a 40% to 50% clip.
Before jumping in, here are some things to consider.
The Upside
Diversification: The product mix that EMS companies handle provides built-in diversification. Most of these companies make a range of products for multiple OEMs, thereby shielding their exposure to a single product or company failure. For example, if Nokia (NYSE: NOK) cuts back on handset production because it is losing market share to Motorola, an EMS company can shift production from Nokia phones to Motorola phones. Either way, the EMS is still producing the handset. Diversification also spans across product types. For example, if Nokia cuts back on phone production, an EMS company can increase production of another electronic product.
Tangible Assets: EMS companies have real earnings and real assets. Unlike many companies with growth rates north of 25%, these guys have liquidation values and more on their balance sheets than goodwill. Just something to hang on to in this turbulent market.
Rapid Growth: The industry or, better yet, industries, are going gangbusters. From cell phones to circuit boards, nearly every industry EMS companies serve is growing rapidly. According to Dataquest, the EMS market is poised for a compound annual growth rate of 25% through 2003. This is a $100 billion market that was only $46 billion in 1995.
High Barriers to Entry: The cost of designing, building, and assembling high-tech electronic gear is an excellent barrier to entry. It is highly complex work with a lot at stake. Do you think Cisco trusts the manufacture of its routers to just anybody? EMS companies must be able to deliver. Reputation and track record play an important role in who gets what business.
Positive Trends: Outsourcing is catching on with the major OEMs and opportunities are abundant. In fact, one of the major sources of new business for EMS companies comes from purchasing the OEMs manufacturing operations. For example, over the last 24 months, Solectron (NYSE: SLR) acquired facilities from IBM (NYSE: IBM), Mitsubishi Electric, Trimble (Nasdaq: TRMB), and Ericsson (Nasdaq: ERICY).
Repair Shops: Just as with the auto business, there is a sizable repair and maintenance business for these highly complex electronic devices. And, who better to repair them than the manufacturer?
The Downside
Thin Margins: Unfortunately, here again, there is a parallel to the auto industry. For the last fiscal year, the five major EMS companies (listed below) posted an average gross profit margin of 8.2% and a net profit margin of 2.9%. Not exactly the margins of a "tech company."
High Volatility: Thin margins drive these companies to push for high volume. This high volume makes them susceptible to short-term fluctuations in demand. Although demand remains high, it is closely watched, and EMS stocks often trade on the slightest changes in economic data.
High Execution Risk: One misstep and it's all over. The high demand and virtually nonexistent inventory of EMS products leaves little room for error. EMS companies must juggle third-party suppliers, manufacturing capacity, production schedules, and very demanding customers.
The Players
There are five major players in the EMS game. Their average total return since January 4, 1999 is 221%, with the worst at 32% and the best at 518%. Market Forward Current
Ticker Cap($bil) P/E Price
Celestica CLS $16.3 46 $80.25
Flextronics FLEX 16.4 34 41.00
Jabil Circuit JBL 11.1 38 58.44
SCI Systems SCI 6.2 19 43.00
Solectron SLR 28.8 32 48.00
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