Tuesday, April 2, 2013

Jabil Circuit Equity Research

A cute way to get to know someone is to ask him or her to describe three qualities that people usually attribute to them. Now consider if you met Jabil Circuit $JBL at a cocktail party (us Europeans invented surrealism after all); what three things would you immediately learn? They missed estimates last time around, Apple $AAPL is a major customer, and it’s on a current PE of 10. Is that enough to start a relationship? It's time to take a closer look.

Jabil Circuit's Market Prospects

It’s been a difficult period for the company. The consumer electronics business hasn’t been firing on all cylinders for a while now, and it's natural for this to feed through into the contract manufacturers. Moreover, they (Jabil etc) are more sensitive because they have already committed their cost structure in order to service contracts. If the end demand turns down then they are usually lumbered with ongoing costs that eat into margins. As such, if you want to tell the direction of its earnings you have to first guess how its mix of end market customers will be performing.

I would argue that this means that companies like Jabil should trade on a lowly PE, but the market is not obliged to agree with me! On the contrary, its stock price seems to follow the direction of its earnings and not necessarily its evaluation. The following chart demonstrates the relationship.

JBL Price / Sales Ratio TTM data by YCharts

So if we are agreeing (I won’t personally but that’s another matter) that the key is to guess the earnings direction then what are the key upside drivers and downside risks to the current forecasts?

Jabil’s End Markets

In order to quickly run through some of the issues going into 2013 I have an earlier article linked here. Jabil operates through three segments, and I’ve broken out Q2 revenue share in the following chart.

It’s a familiar story with the Diversified Manufacturing Services (DMS) segment. Specialized services are doing fine and now make up 31% of total revenues, but the problems with health care & instrumentation (6%) and industrial & clean tech (10%) remain unsolved. The problem with the latter is that the solar industry is still suffering from significant overcapacity thanks to government cutbacks. Revenues were up 11%, but margins eroded a bit thanks to the faster than expected integration of the Nypro acquisition. Indeed, Nypro (healthcare, rigid packaging and consumer electronics) is expected to help drive segmental revenue and profitability going forward.

Of course DMS attracts most of the attention because it contains the part of the business that manufactures plastic casings for the iPhone. Naturally analysts rush to upgrade and downgrade DMS’ prospects based on their view of Apple’s sales. Unfortunately, Jabil is pretty tight lipped over its Apple related work, but it's hard not to conclude that at least some of the extra capital expenditures planned for this year are a consequence. On a more positive note the forecast bounce-back in Q4 could be a good indication for iPhone shipments.

Enterprise & Infrastructure and High Velocity Services

Enterprise & Infrastructure has been performing well with a 12% increase in the quarter, but this business has wafer thin margins. The aim is to get them to 3% by the end of the year.

As for High Velocity Services, this segment covers things like set top boxes, mobile handsets, circuit boards and automotive components. Many of these end markets have been struggling thanks to their exposure to consumer electronics. Indeed, revenues declined 15% in the quarter. However, this segment is predicted to experience a sequential uptick in Q3 thanks to the manufacturing ramp with some new handsets. The uptick is also partly due to a seasonal uptick in some products.

I’ve summarized the last quarter’s segmental growth along with company forecasts for the next quarter.

The story with Jabil is one of a company coming through a difficult period with DMS predicted to grow again in Q4 and HVS & EIS getting to their targeted margins by the end of year.

Going back to what I argued earlier about margins, does this mean that earnings are set to improve and that the stock is a buy right now?

Where Next for Jabil Circuit?

Essentially your decision over buying the stock will rest on your cyclical view of the economy. The good news is that the stock is priced to give you good returns should some strength return to the consumer electronics market. Moreover, key contracts such as its Apple work provide the company with upside potential.

One future concern with Jabil lies with the hike in forecast capital expenditures from $500 to $700 million. This was described as broad based expenditure, but I read it as a response to weak end markets and an attempt to support growth in other areas. It's not a great sign. In addition the stock has the risk of the Nypro acquisition being factored in, and then there is always the headline macro risk.

In conclusion I decided to take a pass, but for those looking for exposure to consumer electronics then Jabil may well fit the bill.

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