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  Can Solectron break out of perpetual turnaround mode?

BENJ GALLANDER and BEN STADELMANN

Friday, March 30, 2007

Despite market wobbles and the sudden and dramatic implosion of the subprime mortgage providers in the U.S., there are few sectors that are so out of favour that virtually any member company would be of interest to a contrarian. One industry that is fairly consistently in the dumps is electronic manufacturing services, or EMS for short.

Everybody knows the global giants that produce the electronic tools and toys of our daily lives, companies like Apple, Dell, IBM and Sony, but what is less understood is that most so-called OEMs, or original equipment manufacturers, are not so "original" at all. In fact, they contract out much of the actual production of electronic goods to a vast supply chain of thousands of EMS providers.

If one believes the old saw that the real money in the gold rush went to the folks making shovels rather than prospectors digging for riches, then EMS ought to be a great business to be in. And indeed it was for the two decades between 1980 and 2000. The amount of tech merchandise being sold accelerated rapidly during this period. But there was much more than that going on.

In the old days, many large successful corporations strove to be "vertically integrated" — by handling multiple stages of manufacturing, slivers of profit could be accumulated right through to the retail level. This methodology is still the norm for the petro-Goliaths that control every aspect of production from prospecting for crude to selling gasoline at the pump.

The tech OEMs went in another direction. For them, the ability to crank out massive quantities of gear, with consistent quality and economies of scale, was of paramount importance. By contracting out the manufacturing cycle, new products could be rolled out to the market rapidly before competitors leapfrogged them into obsolescence. It also meant that capital could be redeployed from building expensive factories to designing the next generation of products.

An EMS pioneer, Solectron got started building electronic controllers for solar energy equipment in California's Silicon Valley. With the personal computer revolution, Solectron moved into printed circuit boards for IBM and then quickly into other components. In 1989, when the corporation went public at $6 (U.S.) a share, annual sales were $130 million. Growth was spectacular, with key customers such as Ericsson, Cisco Systems and Nortel Networks driving revenue to $18.7 billion in 2001. During this period the stock split five times, making an original share worth $1,500 by the peak in December 1999.

When the tech bubble burst, not only did orders dry up, but the company was saddled with huge fixed costs associated with an acquisition binge during the 1990s. The business model — based on low margins but high capacity utilization — collapsed. It's been five long years since the crash, and Solectron's stock price remains at a moribund level. A comparison with its main EMS competitors, Sanmina and Flextronics, shows a similar pattern. Closer to home, Celestica has been a forlorn company with a tale of woe. Only Jabil Circuit has been able to buck the trend and become decently profitable.

Though Solectron seems to be locked in perpetual turnaround mode, with large ongoing restructuring and impairment charges, we do see evidence of substantive progress. Long-term debt has been chopped from over $5 billion in 2001 to around $600 million. With a cash horde of over $1 billion, the company has been buying back shares.

Revenues are finally going in the right direction again — the second-quarter tally just announced is a 16 percent improvement over the same period last year. And the corporation's customer base is more diversified than ever, with moves into new areas such as medical instruments. We picked it up for the Contra portfolio at $3.11, with a target price of $11.24, still light years from the previous highs.

One recent disquieting event has been the defection of CEO Mike Cannon to Dell. Mr. Cannon presided over Solectron's restructuring over the past four years, and though he deserves credit for putting the company on a more solid footing, he failed to solve the riddle of how to improve margins and make consistent profits. That will take someone with a visionary spark to adapt the EMS business model to the changing contours of the global tech landscape.


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