(FORTUNE Magazine) – Seated next to conveyors in a low-rise building that once housed a bicycle plant, workers with busy fingers stuff circuitboards with components. At the next station, fast-moving operatives insert the boards into beige molded-plastic housings. Finally a printing machine applies the model name and company logo, and each item gets wrapped in retail packaging. Voila, ready for export, we have another carton of surge protectors--those plug-in boxes that guard sensitive microchips from the ravages of lightning bolts and power spikes on the electric grid.

A typical Third World manufacturing shop manned by workers earning less than a dollar an hour? Guess again. This is the production floor at Panamax, a maker of premium-quality surge protectors in California's ultraprosperous Marin County. Wondrous to tell, the plant exports some of its finished goods to Mexico, a low-wage country in the grip of economic crisis.

That's just one of the surprises encountered in talks with U.S. companies pursuing profits in Mexico in the wake of Nafta, the controversial trade agreement that went into effect in January 1994. With one stroke, it swept away trade barriers between the U.S., Mexico, and Canada in most manufactured goods and in such services as insurance and banking.

Cashing in on NAFTA south of the Rio Grande would appear to be an uphill fight these days. Mucho grim times have gripped Mexico since late 1994, when the peso went into a free fall that halved its value vs. the dollar and triggered the country's deepest recession since 1932. With unemployment widespread and purchasing power in the dumps, Mexico has got to be a hopeless customer, right?

Not necessarily. Sure, it's a tough place to thrive right now, but signs indicate that the worst is probably over. Mexico's gross domestic product, which slid 7% in 1995, shrank only 1% in the first quarter of this year, defying the Mexican government's forecast of a 3% decline. What's more, although 1995 sales of U.S. goods to Mexico trailed the previous year's by almost 9% and America's trade surplus turned into a deficit, the $46 billion export total was actually nearly $5 billion higher than that of the year before NAFTA. And under NAFTA, the U.S. share of Mexico's import market has risen from 70% to 75%, according to U.S. Commerce Department figures.

Listen to William Clayton, 63, who has witnessed Mexico's ups and downs since 1956, when his company, Clayton Industries, opened a plant there to make steam-cleaning equipment: "The economy has stabilized, and with the devalued peso, Mexico is a much more attractive place to produce things."

The fact is that like Panamax and Clayton, many U.S. companies are doing reasonably well in Mexico--earning profits or breaking even, and expecting to do much better when good times return. Among these firms, of course, are familiar names from the Fortune 500, such as the Big Three car and truck makers that have long manufactured in Mexico and Deere & Co., which recently announced that it will build a Mexican plant to make diesel engines.

But some of the most instructive tales are told by small and medium-size companies in California, which has a natural affinity with Mexico. These outfits are doing a fascinating variety of things that show there's more to NAFTA than relocating labor-intensive production lines from New Jersey to Nuevo Laredo, or shipping machinery duty-free from Milwaukee to Monterrey. Here are the niches in which several are succeeding:

DISPOSING OF TOXIC WASTE. The NAFTA treaty, definitely not a quick read at almost 2,000 pages, contains an important side agreement that has opened an especially rich vein of opportunity for the norteamericanos. Included at the insistence of U.S. environmentalists and union leaders alarmed that Mexico was becoming a haven for companies fleeing tough U.S. pollution laws, this side agreement requires Mexico to show progress in cleaning up its smoggy air and defiled rivers.

This was a signal for Metalclad, a $20-million-a-year company in Newport Beach, California, to go big-time south of the border. Founded in 1933 to exploit a patented process for applying metal coating to insulated pipes in factories, Metalclad began branching into the Mexican environmental services market in 1991, investing about $5 million in an array of waste recycling and disposal operations before NAFTA took effect. That investment has since ballooned to more than $30 million. In hopes of becoming an even bigger presence, Metalclad and a Mexican partner recently formed a joint venture, called BFI-Omega, with Browning-Ferris Industries, the big waste-management company headquartered in Houston.

Among Metalclad's Mexican operations is a service that provides workshops and garages with environmentally friendly parts-cleaning equipment; it employs a solvent that is later filtered, distilled, and reused. Another operation collects used crankcase oil from garages. Formerly, much of the waste oil drained from Mexican engines was simply dumped down storm drains; now Metalclad blends this toxic goo into an industrial fuel. The product fires kilns at plants in the state of Hidalgo owned by Cruz Azul, a major cement producer and Metalclad partner. The 2,400-degree temperature in the kilns incinerates toxins in the waste oil, and the cement company realizes savings over the cost of fuel oil it would otherwise have to buy.

The very fact that Metalclad's business in Mexico is growing bears witness that a cleanup is under way. Mexico's pollution laws, modeled closely on U.S. Environmental Protection Agency rules, are increasingly being enforced by an expanded cadre of officials, backed by bigger budgets and the authority of the country's federal government. From the standpoint of Grant Kesler, 53, Metalclad's soft-spoken president, Mexican field inspectors who hand citations to polluters "are like a marketing arm that lets us know where the new business is." And under NAFTA, Metalclad no longer has to pay a 20% tariff on environmental equipment it brings into Mexico.

Kesler cites another reason NAFTA has made Mexico more inviting. The trade agreement's provisions for resolving contract disputes with Mexican companies, he says, "have brought a certitude that wasn't there before." This in turn has helped bolster the confidence his company needed to finance rapid expansion in Mexico. Often in the past, an American company at loggerheads with a Mexican one had to take its chances in the Mexican courts. But under NAFTA, companies are encouraged to avoid the courts by putting provisions in contracts that call for arbitration by recognized international bodies. Clyde Pearce, an attorney in Salinas, California, who has advised Metalclad and other companies, says that "NAFTA creates an unquestionable obligation on Mexico to enforce arbitration awards" even though such cases haven't yet been through the courts.

MAKING THE WATER SAFE TO DRINK. Another company riding Mexico's cleanup wave is U.S. Filter Corp. in Palm Desert, California, a fast-growing, $272-million-a-year supplier of water treatment equipment and services. At its headquarters in the parched Mojave desert country east of Palm Springs, fountains burble next to an office building crafted from stone and timber. The water theme is a happy coincidence: A real estate developer who later fell on hard times was the original occupant.

Richard Heckmann, 52, U.S. Filter's CEO, is a financial type by background who has been expanding his publicly owned company by aggressively buying up firms with water treatment expertise. Exports are an important part of the picture, currently accounting for a third of sales. So it was natural to look to Mexico, where approximately 50 cities with 300,000 or more people don't treat their sewage at all, and diseases like cholera are a major problem.

Heckmann first heard about the water treatment needs of Mexico's fast-growing population at an environmental conference in 1992. Impressed by a speaker's arguments that NAFTA would help attract foreign investment for improving Mexico's infrastructure, Heckmann later testified before a Senate committee in favor of the trade agreement.

NAFTA meant that there would finally be "a U.S. government statement that people trading in Mexico would be protected," Heckmann says. According to him, the list is long of companies that went to Mexico in the 1960s through the 1980s and "just got killed. They got into bad partnerships and got treated like gringos. In the old days, if you had a disagreement you were stuck in a court system that didn't favor the foreigner."

In addition to protecting companies dealing with private parties in Mexico, NAFTA provides new safeguards for those like U.S. Filter that deal extensively with the Mexican government. If U.S. companies incur losses on investments because of the government's failure to honor its obligations, they can take their claims to arbitration rather than the Mexican courts, and Mexico is required to abide by the arbitration awards. What's more, Heckmann adds, "we have a terrifically responsive U.S. embassy in Mexico City headed by Ambassador Jim Jones, who sends the message that he's ready to rattle cages if somebody gets ripped off. NAFTA and our committed embassy are what convinced me to do business in Mexico."

U.S. Filter has supplied industrial water treatment systems for a Samsung TV picture tube factory and a Chrysler automobile plant in northern Mexico. It also operates sewage treatment plants that it built in the cities of Yautepec and Cuernavaca. The industrial customers paid their bills in cash, but arranging financing for the municipal treatment plants has been a rough ride, made even bumpier by the peso's woes.

Agencies like the U.S.'s Eximbank don't lend or guarantee loans to local or regional governments in Mexico because the agencies can't come to terms with the country's federal government over guarantees. Heckmann ended up arranging financing secured by Banobras, Mexico's national development bank, but feels that the scarcity of funding options remains an impediment to launching needed civil-engineering projects. "Mexico has got to arrive at some better funding agreement. If the Eximbank would guarantee financing, for example, we'd have ten of the these treatment plants operating."

Doing business in Mexico, Heckmann says, calls for flexibility in dealing with the unexpected. When dynamiting to prepare the foundation for the $14 million Cuernavaca sewage treatment plant broke windows in an adjacent neighborhood where fat cats reside, the Mexican army appeared and brought work to a halt. That impasse was resolved by paying several dozen workers to complete the rock breaking with picks and hammers. Despite this inconvenience, construction was completed on schedule in four months.

The plant is an obvious blessing. By treating its sewage instead of discharging it raw into the Yautepec River, the previous practice, Cuernavaca improves the health of communities downstream. Meanwhile, local farmers get free nutrient-rich sludge for fertilizing their fields. The plant employs 15 workers, all Mexican. U.S. Filter built the treatment plant under an agreement that it would own and operate the facility until 2009, when the local government was to have repaid all construction costs and taken possession.

But the peso's collapse forced a modification in this arrangement. The state of Morelos, where Cuernavaca is located, suddenly found itself faced with debts repayable in devalued pesos. "Within a week of the devaluation, we got a call from the governor's office," Heckmann recalls. "He didn't try to hide the repayment problem. Instead he invited me to his house--which is an important honor in Mexico--along with some of his officials." A compromise was worked out under which U.S. Filter extended the life of its operating contract by four years, in effect giving the regional government until 2013 to complete the installment purchase of the plant. The upshot, in Heckmann's view, is that "nobody lost anything."

SELLING SURGE PROTECTORS. As trade statistics and Panamax's success demonstrate, Mexico is buying lots of U.S.-manufactured products even in hard times. Now 21 years old, privately held Panamax is located in San Rafael, California, where it can minimize inventories by using local parts suppliers. Mexico's growing use of computers makes it a natural market, even during a recession. "No matter what the value of the peso is, people still want to protect their computers and telephone equipment," says Henry Moody, 60, president of the 175-employee firm. Panamax's sales are running "in the tens of millions of dollars," he says, about 10% of which are exports. Last year the Commerce Department recognized the firm with the President's E Award for excellence in exporting. Moody estimates that exports to Mexico support about 15 of those jobs. "We've gotten more market share there under NAFTA."

Panamax is currently working flat out on three shifts to assemble surge protectors it sells under its own name and to companies such as Xerox and Canon under private labels. High quality and performance have enabled Panamax to win blue-chip customers. At retail prices of $69 to $299, its surge protectors cost more than many others on the market but are guaranteed to hold off the 40,000-amp surge triggered by a direct lightning strike, far beyond the protective capacity of those $15 Chinese-made jobs sold with home computers.

Panamax began shipping to Mexico in 1993, when it started supplying surge protectors to Xerox de Mexico and to builders of uninterruptible power supply equipment that was being shipped south. Then NAFTA took effect, and Panamax got a welcome break: The tariff on most of its products dropped from 27% to zero. At the same time, Mexico raised tariffs on competing equipment imported from Asian countries as high as 129% in the case of China. Panamax uses some Asian parts, but the North American content is sufficiently high to let its goods move duty-free within the North American bloc.

The move that anchored the company's Mexican presence was the establishment of relations in Mexico City with Ingram-Dicom, a large distributor of home and business computers. The company has become Panamax's best customer in the country; Panamax has helped it weather the recession by stretching out accounts-receivable payments. Panamax has also adjusted its product mix to the market's ability to pay.

The obvious question is whether Panamax has considered manufacturing in Mexico, especially with the peso so weak. Its labor costs in Northern California, after all, are about $73 a day counting benefits, vs. a bit more than $3 south of the border. Moody quickly answers: "We don't have to move our production out of the U.S. 'Made in the U.S.A.' sells in Mexico, and with our manufacturing skills and the tariff break under NAFTA, we are efficient right here." In any case, Moody says, labor is only 10% of the cost of manufacturing.

MAKING STEAM GENERATORS. The company with the longest perspective on Mexico is Clayton Industries in El Monte, California. It first built a factory in Mexico 40 years ago to make its original product, steam cleaners for automobile engines, for the local market. The move was prompted by Mexico's imposition of tariffs that would have made Clayton's U.S.-made machines too expensive for Mexicans to afford.

From steam cleaners, the Mexico City factory moved on to bigger stuff: steam generators that supply heat for industrial operations ranging from food processing to auto-parts manufacturing and sell for $15,000 to $150,000. Fourteen years ago Clayton Industries built another Mexican factory, in Tijuana, that supplies welded and fabricated parts to the company's assembly plant in California. Today Clayton commands about a 30% share of Mexico's steam generator market; its Mexican plants have about 200 employees, 40 fewer than in easier times before the peso crash.

Supporting NAFTA made intuitive sense to CEO William Clayton, who believes that in the long run, all ships ride higher on the waters of free trade. Once the agreement was adopted, he says, the order book began filling as foreign companies planned new factories to satisfy anticipated growth in Mexico's domestic markets. Then the peso bombed, causing many companies to shelve expansion plans.

Today Clayton is cautiously optimistic. The Mexican recession may already have bottomed out, he says: "We're beginning to see some of these projects come back to life." That doesn't mean that Mexico's economy is out of the cactus grove. For the short term, Clayton believes, "I think the smart money will wait a while longer to see whether President Ernesto Zedillo is going to be able to achieve long-term social and economic stability." No doubt he's right. But companies with unique products and services that Mexico can't do without--and a willingness to work out creative financing--need not sit on the sidelines.

REPORTER ASSOCIATE Alicia Hills Moore