Flextronics a Bargain with 70% Potential

04/05/2011 11:57 am EST

Focus: GLOBAL

After making money at the nadir of the recession, the unloved contract manufacturer is poised for upside, writes Paul McWilliams of Next Inning Technology Research.

While there are numerous risks for Singapore-based contract manufacturer Flextronics (FLEX), I continue to believe Wall Street is weighing these risks far too heavily—ignoring the strong performance Flextronics provided through the downturn and subsequent economic recovery.

If the company executes in line with my expectations, and we don’t suffer a notable decline in macroeconomic activity that would hamper its revenue growth, we’ll see the price move towards, if not into, double digits in 2011. [Shares traded at $7.22 Tuesday—Editor.]

The primary weights on Flextronics shares this year have been:

  • the company's leveraged balance sheet;
  • the markets' risk aversion since mid-February.

That said—as I wrote in 2008, when the share price crashed to nearly $1—I believe Wall Street is dead wrong here in applying such a substantial risk discount.

Throughout the 2008 to 2009 recession, Flextronics maintained a positive non-GAAP operating profit margin, and cash flow was so strong it actually paid down debt ahead of schedule—and under highly favorable terms—during the trough of the recession.

The vast majority of the debt reduction was done with cash from operations. (Flextronics maintained profitability throughout the recession.) Based on this performance, I don’t see Flextronics’ still-slightly leveraged balance sheet as a substantial risk at this juncture.

Big in China
With roughly 45% of its more than 200,000 employees working in China and driving about a third of the company’s total revenue, Flextronics has a fairly high exposure to China, and may see some upward pressure on its operating costs due to pressures there for higher wages and improved working conditions.

However, since the full impact of those costs should have been seen during the fourth quarter, and Flextronics still managed to boost its operating profit margin to 3%, it appears improved scale and other efficiencies offset anticipated higher wage costs.

With a new and efficient plant in what is one of the lowest labor-cost areas of China, Flextronics should be able to compete effectively and grow its market share.

Beyond expanding its footprint in high-volume markets with companies like Dell (DELL), Hewlett-Packard (HPQ), Lenovo, Acer, Casio/Hitachi and Research in Motion (RIMM), Flextronics has also expanded its coverage of the medical sector with the acquisition of SloMedical S.R.O., a leading European manufacturer of disposable medical devices ranging from tubing sets to complex devices for minimally-invasive surgery.

NEXT: A Jack of Many Trades

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A Jack of Many Trades
Flextronics has also expanded its work with Lenovo in Europe and India, so that its European operations now generate about 19% of total revenue.

The company should begin to see some upside from Lenovo, which expanded its relationship with Flextronics in late 2009 by adding assembly for some of its desktop models as well as servers and workstations.

We should also begin to see upside from Ericsson (ERIC), which acquired Nortel’s CDMA wireless business, and from Avaya, which acquired Nortel’s enterprise business. In addition, my bet is on some upside from Motorola Mobility (MMI), now that it is regaining some popularity in the handset space.

Flextronics has stated it expects to be able to grow revenue at a rate of 10% to 15% per year. This growth is expected to be fueled by expanding its reach into a variety of areas beyond traditional electronics contract manufacturing activity.

Unsung Value Proposition
Normally, credible growth stories of this nature and scope would be rewarded with a fairly high valuation multiple. However, because analysts have consistently viewed Flextronics as a high-risk investment due to its leveraged balance sheet, I’m maintaining the range of ten to 12 times earnings I’m using throughout the sector.

If we run our value model based on a range of earnings estimates that runs from the $1.03 consensus (up $0.06 from the $0.97 consensus we used 90 days ago) to the $1.20 (high side of my $1.10 to $1.20 range), use a valuation multiple range running from ten to 12 times earnings, and adjust the result downward to offset FLEX’s negative net current asset value of $0.56 per fully diluted share, the resulting estimated fair value range runs from $9.74 to $13.84.

There are three elephants sitting in Flextronics’ parlor. One is the company’s relatively high exposure to the PC market—and even though I don’t personally buy into it, many analysts are still expecting soft PC demand in 2011.

The second is FLEX’s stated intent to expand more heavily into the motherboard assembly and PC original-design manufacturing. These markets have historically carried very tight margins and been highly competitive.

The third elephant is Flextronics' components business. Flextronics has so far failed to drive operating profit margins in this business to its stated goal of 4%. If we see signs that the company will realize that goal, I think Wall Street will react very positively.

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