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Our Outlook for the Hardware Sector

We see opportunities in the contract manufacturers.

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In spite of recent noise surrounding the mortgage market and its potential impact on the broader economy, we believe the overall IT industry should remain healthy. While our longer-term outlook of midsingle-digit growth may seem a little uninspiring, we think technology investors who recall the vagaries of the 2001 recession can take comfort in the current environment of relative stability.

One important trend that will become more pronounced over the next few years is the tremendous power that original equipment manufacturers (OEMs), such as  IBM (IBM),  Hewlett-Packard (HPQ), and  Cisco (CSCO), exert over the entire supply chain. OEMs are aggressively managing working capital, improving the amount of time it takes to convert a dollar of revenue into cash flow, while pushing inventory risk onto others in the supply chain. Additionally, these companies are continuing to outsource a larger portion of hardware manufacturing in order to drive down costs and free up resources for product development and marketing. Even smaller OEMs are adopting these strategies in growing numbers, and we expect this trend to continue into the foreseeable future.

This outsourcing trend will fuel a growing EMS market that is split between two distinct segments: high-volume, less complex assemblies (such as desktop computers and handsets) and low-volume, more complex assemblies (such as medical devices and industrial equipment). We believe large, vertically integrated contract manufacturers such as Hon Hai and  Flextronics (FLEX) will be best able to compete in the high-volume market. Smaller, more specialized firms with flexible manufacturing capabilities, such as  Benchmark (BHE) and  Plexus (PLXS), are well positioned in the low-volume market. Most of the EMS providers under our coverage currently compete in both segments. However, we think firms that continue to pursue both markets risk falling behind as they become "stuck in the middle," as described in Michael Porter's classic book, Competitive Strategy.

Valuations by Industry
Our average star rating for the hardware sector is about 2.94, suggesting that the sector, on average, is fairly valued. Looking across the table, we see that individual segments are, by-and-large, also fairly valued. The contract manufacturers are a notable exception. On average, this group is undervalued, in our opinion, and we see potential opportunities for investment.

 Hardware Industry Valuations
Segment

Average
Star Rating

Median
Price/Fair Value
Stocks Covered
Components 2.60 1.08 10
Computer Equipment 2.84 1.07 34
Contract Manufacturers 3.89 0.90 9
Data Networking 2.78 0.98 9
Optical Equipment 2.80 0.93 5
Semiconductors 2.96 0.97 58
Semiconductor Equipment 2.60 1.09 30
Wireless Equipment 2.83 1.08 13
Wireline Equipment 3.69 0.80 14
Data as of 9-19-2007.

Although the midsized, U.S.-based contract manufacturers are at the greatest risk of becoming stuck in the middle, we believe current stock prices are overly pessimistic. The market tends to take a rearview mirror approach to investing, and we think investors are still holding on to the 2000-02 time period when this group collectively lost more than $40 billion in market value as the tech bubble collapsed.

Growing competition from Asia-based contract manufacturers is driving the latest round of pessimism, with Hon Hai being the most notorious. We don't dispute that Hon Hai is a threat, particularly because of its strong customer base and massive scale. But the market has room for other players. Hon Hai's enormous revenue base should continue to steer the company's sales efforts toward high-volume customers who can meaningfully contribute to growth. This will leave an abundance of opportunities for midsized EMS providers to win contracts from small and medium-sized OEMs overlooked by Hon Hai. We think the diverse needs of these smaller OEMs, from complex medical-imaging equipment to simple (but lower-volume) electronic preschool toys, will continue to provide a fertile market. Also, these smaller firms will be more willing to pay up for value-added services, such as supply-chain management and design-engineering assistance, which should boost profits.

In this environment, midsized U.S. contract manufacturers need to maintain flexible manufacturing processes and offer extended services to gain share in the fragmented, and growing, small and midsized OEM market. Trying to go toe-to-toe with Hon Hai or Flextronics for high-volume business will be too challenging. We think these midsized firms understand this environment, and will adapt their business models accordingly. Although EMS firms generally have no competitive advantage and make unattractive long-term investments, we believe that Mr. Market's panic has created some potentially shorter-term opportunities for the risk-tolerant investor.

Hardware Stocks for Your Radar

 Stocks to Watch--Hardware
Company Star Rating Fair Value Estimate Economic
Moat
Risk

Current Strategy 

Jabil  $32 None Average Mix
Celestica $10 None Above Avg Mix
Sanmina $4.50 None Above Avg Mix
Flextronics $13 None Above Avg High Volume
Nam Tai $12 None Above Avg High Volume
Data as of 9-25-2007.

 Jabil's (JBL) 30% exposure to networking and computers puts the company directly in Hon Hai's line of fire, but we think the market has overreacted to this risk. In our view, Jabil is one of the best-run of the U.S. contract manufacturers. The company builds its components along dedicated customer lines, called "work-cells." This dedicates teams of workers and production lines to a single customer, which improves accountability and customer service. It also gives Jabil more flexibility in its manufacturing processes, as it can simply build capacity around each customer's unique needs. We think this makes Jabil an attractive option for OEMs, such as medical device makers, that produce a broad line of complex equipment. We believe that medical equipment will continue to be one of the most lucrative EMS market segments over the next five years.

 Celestica (CLS) is another company where investors have turned overly fearful, in our opinion. The company has been plagued by operational problems in its Mexico-based manufacturing plants and has lost a number of large contracts as a result. This is especially troubling considering the $1.5 billion in restructuring charges the company has taken over the past three years to trim excess capacity. However, Celestica has been diversifying its customer base by adding new customers in the industrial and military industries. Frankly, we don't believe it can get much worse. We think Celestica is pursuing the right strategies for future profitability. Although we don't recommend this company as a long-term investment, we believe its stock is currently too cheap to ignore.

 Sanmina (SANM) also falls into our "too cheap to ignore" bucket. The company has spent more than six years closing manufacturing plants and downsizing its workforce. Similar to Celestica, Sanmina has had its share of operational missteps. For example, in 2002 the company relocated certain high-volume manufacturing plants to low-cost regions in China in an effort to save costs. Although this is a sound strategy that has been adopted by most EMS firms, Sanmina's execution was poor. The company couldn't qualify its customers quickly enough in these new facilities and lost a number of contracts to competitors. In spite of these problems, we think Sanmina is now focused on the right markets as it works to divest its PC business and focus on growing its low-volume business.

We are neither overly excited nor overly concerned with  Flextronics(FLEX) future prospects. The company should continue to enjoy revenue growth thanks to its breadth of service offerings and global network of high-volume manufacturing plants in low-cost regions like Asia. We believe the Solectron acquisition gives Flextronics the scale it needs to compete with Hon Hai on high-volume assemblies, while strengthening relationships with large tier-one OEMs such as Cisco and Hewlett-Packard. On the downside, profit margins will be tight, as Flextronics will be competing primarily on price for these contracts. In all, we would consider an investment in this EMS giant only at a significant discount to our fair value estimate.

Given our 3-star rating and the risks facing  Nam Tai (NTE), we think investors can find more attractive opportunities elsewhere in the EMS sector. The company has grown its revenues by an average of 30% over the past three years, which has attracted the market's attention. However, most of this growth can be attributed to the company's large exposure to the maturing mobile phone industry (camera phones, specifically), which we expect to moderate. Nam Tai has no manufacturing capabilities outside of China, and nearly all of its revenues are from consumer electronics. This makes Hon Hai a direct competitor, and with less than $1 billion in annual revenues, Nam Tai won't be able to compete.

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Grady Burkett does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.