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News > Technology
Power of 'Brand-X' techs
June 5, 2000: 12:55 p.m. ET

As big-name equipment makers rush to outsource, contract manufacturers shine
By Staff Writer Richard Richtmyer
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NEW YORK (CNNfn) - Think you know who built that new computer or wireless phone you just bought? If you say it was the company whose brand name is printed on the box, chances are you'd be wrong.

That's because technology outfits such as Compaq, IBM, Lucent and Motorola are increasingly outsourcing big parts of their manufacturing operations to more obscure companies that specialize in building computers and other electronics.

You won't find names such as Solectron, Flextronics or Celestica stamped on any products. Nevertheless, these companies and a handful of others have quietly become an integral part of the "new economy."

Though they've caught the eye of Wall Street recently in the wake of several multibillion dollar outsourcing contracts, the companies that provide electronics manufacturing services, or EMS, have not drawn the same kind of broad investor attention as their big-name customers.

But the surging demand for electronics and the fierce competition among original equipment manufacturers, or OEMs, have driven outsourcing to levels never before seen. And EMS executives and analysts see that trend accelerating, which they say makes EMS stocks a relatively safe way to play the technology sector.

"In our view, you not only get the exposure to technology by investing in these, you get a dynamic secular trend toward outsourcing that's probably in the third inning of a nine-inning game," said J. Keith Dunne, an analyst who covers the EMS industry for Robertson Stephens in San Francisco.

"We're only 20 percent outsourced, and we think that's going toward 60 or 70 percent over the next three-to-five years," Dunne added.

graphicWhile the idea is not new, outsourcing in the electronics industry has taken off in recent years. Growing cost competitiveness and a lowering of geographic boundaries have been among the primary drivers behind the trend.

By farming out their manufacturing to contract manufacturers, OEMs save money, reduce the amount of time it takes them to get new products to market, are able to focus on their core competencies such as design and development, and benefit from the EMS companies' economies of scale.

The lowering of trade barriers also has played a big part in the recent outsourcing boom, according to Michael Marks, chief executive of Flextronics, which recently inked a $30 billion, five-year outsourcing agreement with Motorola, the largest deal in the history of the industry.

"The manufacturing locations in the world that are emerging as the right places to be are different places from where the OEMs have historically built their facilities," Marks said.

China, Central and Eastern Europe and Mexico in recent years have become centers of electronics manufacturing. But the big OEMs have not invested heavily in those regions, he said.

graphic"These locations have developed very recently," Marks said. The Iron Curtain fell in 1991, so it's really just in 1994 and 1995 that Central and Eastern Europe became a really great electronics manufacturing location to serve Europe. NAFTA was in 1994, so it wasn't until 1995 through 1997 that Mexico became a good site.

"What you see over the last two years is that the deals are getting increasingly larger," Marks added.

Since 1996, the top six EMS companies - Solectron, Celestica, Sanmina, Jabil Circuit, Flextronics and SCI Systems - have, in aggregate, grown their annual revenues at more than 30 percent, while their net income has grown roughly 47 percent, according to Jim Savage, an analyst at Thomas Weisel Partners in New York.

A narrowing field


There are hundreds of companies that engage in contract electronics manufacturing. But a wave of consolidation over the past several years has narrowed the top-tier - those who are increasingly being selected by the large, multinational OEMs - to fewer than 10.

Until a recent spike in the sector this week, their stocks had been selling at roughly 30 times next year's forecast earnings and in general the companies have had about a 40 percent long-term growth rate. That makes them something of an anomaly among technology stocks, Savage said.

"They have been selling at a discount to their growth," he said. "You don't find too many key technology and large technology companies, as many of them are, at this point, selling at a discount to their growth rate."

graphicAnd over the past year, the top-tier EMS companies have far outpaced most of their counterparts in the tech sector.

Solectron (SLR: Research, Estimates) shares are up 77.8 percent; Celestica (CLS: Research, Estimates) is up more than 145 percent; Sanmina (SANM: Research, Estimates) stock is up 92.5 percent; Jabil Circuit (JBL: Research, Estimates) is up 70.2 percent; Flextronics (FLEX: Research, Estimates) is trading more than 157 percent higher; and SCI Systems (SCI: Research, Estimates) shares added 136.3 percent from a year ago.

Meanwhile, the tech-laden Nasdaq composite index added 48.5 percent during that same period.

"The only place that we've been able to identify where there is growth like this is in the Internet," said Robertson Stephens' Dunne. "But you've got proven business models here. We've been watching the operating income lines growing 50 percent from some of the leading players."

No investment, however, comes without risk. And the EMS industry is no exception to that rule.

The same demand for electronics that has been fueling the outsourcing trend has created a supply crunch for a range of the electronic components EMS companies need to build the products. That could cause some disruptions to their businesses, according to Savage.

In a recent report on the industry, Merrill Lynch analyst Jerry Labowitz characterized it as "a less expensive and more diversified way to invest in technology," but warned that the pace of outsourcing could cause some problems for EMS companies that try to take on too much new business too soon.

Who's afraid of a recession?


Concerns that a slowdown in the U.S. economy could stifle the growth of some of the high-flying technology stocks were largely behind the sector's downturn, which began in late March. And lingering concerns and uncertainty about economic growth have been largely to blame for the volatility in the tech sector in recent weeks.

But rather than slow down growth in the EMS industry, a downturn in the U.S. economy would be beneficial, according to Thomas Weisel's Savage. Slowing and uncertain end-markets have historically driven higher levels of outsourcing, he said.

"Obviously, they will trade, to some extent, with their customers," Savage said. "But If you look at the drivers of their growth, they are counter-cyclical. Even if we look at an economy that's slowing down, the major driver of the growth of EMS companies is not the strength of the end markets, it's the outsourcing trend. And the outsourcing trend is accelerating and will continue to drive 75- or 80-percent of the growth of these companies over the next few years."

Flextronics' Marks said that even if the economy fell into a recession, some of the markets that are driving his company's business, especially communications, are not going to turn down.

"The entire wireless telecommunications infrastructure is going to be upgraded in the next five years, and that's going to happen whether the economy is good or bad," he said. "Once that's done, every handset, every wireless Palm Pilot, every portable computer is going to get upgraded, and we do work in all those segments." Back to top

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