With Inventory Up, Demand Down, Analysts Downgrade Contract Manufacturers

Somewhere out there, a box filled with silicon parts has been shrink-wrapped and placed next to another shrink-wrapped box. Repeat this process until thousands and thousands of cases are packed with simple shrink-wrapped boxes.

Now, stuff these cases filled with boxes into hundreds of warehouses, add in that heap of already opened equipment on countless shelves around the globe and maybe, just maybe, the massive inventory glut will begin to make sense.

As these components for telephones and computers and routers pile up, demand and prices (and eventually, earnings) fall. The deceptive simplicity of supply and demand has punched a hole into the just-in-time manufacturing process, which works wonderfully well when money is flush. Now, few companies need anything next quarter, let alone right now. And so it goes. The stuff piles up.

Today, with that inventory problem weighing heavily on Wall Street, analysts dropped ratings and estimates on a bunch of electronic contract manufacturers, once considered a safe haven in a recession. Demand has dried up across the board, say the analysts.

"We have never seen a slowdown of such speed and breadth in over 30 years," wrote Credit Suisse First Boston analyst Mark Hassenberg in a Tuesday morning note to investors. "Worsening the magnitude of the downturn are excess inventories of products currently in the market that companies are trying to obsolete."

All over Wall Street, estimates were trashed in the wake of Monday night's warnings from KLA-Tencor (KLAC Quote), which makes chip equipment, and Solectron (SLR Quote), which provides manufacturing services to a wide array of industries like networking, servers, telecommunications and PCs. Goldman Sachs dropped forecasts on seven companies that do similar things, snipping at Flextronics, Solectron, Benchmark Electronics (BHE Quote), Plexus (PLXS Quote), Sanmina (SANM Quote), SCI Systems (SCI Quote) and Celestica (CLS Quote). CSFB cut 2001 forecasts on Flextronics, Solectron, Molex (MOLX Quote) and KLA-Tencor.

A Contract Hit
Company	New 2001 EPS	Old 2001 EPS	Rating
Credit Suisse First Boston
Flextronics	$0.90	$0.92	buy
Solectron	$0.78	$1.23	buy
Molex	$1.32	$1.37	buy
KLA-Tencor	$1.80	$1.85	buy
Goldman Sachs
Celestica	$1.75	$2.05	U.S. recommended for purchase list
Flextronics	$0.90	$0.91	U.S. recommended for purchase list
Benchmark Electronics	$1.90	$2.30	market outperform
Plexus	$1.30	$1.45	market outperform
Sanmina	$1.20	$1.37	market outperform
SCI Systems	$1.35	$1.41	market outperform
Solectron	$0.83	$1.17	market outperform
Prudential Securities
KLA-Tencor	$1.80	$2.10	accumulate
Solectron	$0.93	$1.19	hold
ING Barings
Celestica	$1.95	$2.05	buy
Flextronics	$0.90	$0.92	buy
Jabil Circuits	$0.90	$1.02	hold
Sanmina	$1.35	$1.40	buy
SCI Systems	$1.38	$1.47	hold
Solectron	$0.95	$1.23	hold
Robertson Stephens
KLA-Tencor	$1.83	$2.11	accumulate
Solectron	$0.93	$1.25	accumulate
Merrill Lynch
Solectron	$0.86	$1.18	buy
Bear Stearns
Solectron	$0.95	$1.27	attractive

But wait. There's more. Robertson Stephens cut KLA and Solectron, the two earnings warners, to long-term attractive from buy. Prudential Securities cut Solectron to hold from accumulate. ING Barings dumped ratings on six companies, dropping Celectica, Flextronics and Sanmina to buy from strong buy and Jabil Circuits (JBL Quote), SCI Systems and Solectron to hold from buy. Bear Stearns cut those six companies and Viasystems (VG Quote) to attractive from buy.

Ratings Lowered, Too.
Company	New Rating	Old Rating
Bear Stearns
Celestica	accumulate	buy
Flextronics	accumulate	buy
Jabil Circuits	accumulate	buy
Sanmina	accumulate	buy
SCI Systems	accumulate	buy
Solectron	accumulate	buy
Viasystems	accumulate	buy
ING Barings
Celestica	buy	strong buy
Flextronics	buy	strong buy
Jabil Circuits	hold	buy
Sanmina	buy	strong buy
SCI Systems	hold	buy
Solectron	hold	buy
Robertson Stephens
KLA-Tencor	long-term attractive	buy
Solectron	long-term attractive	buy

Two warnings buried the sector, but the dirt and shovels have been there for a while.

Last night, KLA-Tencor warned that third-quarter revenue would fall up to 10% lower than the previous guidance given on Jan. 17, coming in well short of earnings estimates. A plethora of reasons were cited for the miss, including excess inventory, deferred deliveries, delayed orders and low demand. And going forward, the company said the situation was unclear, quite the reversal from January, when it said that third-quarter revenue would be in line with expectations, coming in between $570 million and $580 million. At the time, the analysts, on average, expected $577.5 million.

The good news might not come for a while. "In our view, overall business fundamentals could continue to deteriorate until late summer," wrote Prudential analyst Shekhar Pramanick. "[The stock] could continue to trade in the trading range. We would add positions only at the end of the trading range."

Meanwhile, the world's largest equipment-manufacturing service provider, Solectron, said it would miss sales figures for 2001. The company once sought to top $23 billion in sales for 2001, but shelved that goal, putting third-quarter revenue between $4.1 billion and $4.5 billion. That's quite a downturn from the last two quarters, when the company booked $5.7 billion and $5.4 billion in the first and second quarters, respectively. And to make matters worse, the company didn't give guidance for 2001. With sales down, the giant cut costs, slashing 8,200 jobs from its workforce, which is 79,000 strong.

"In light of the flattish year-over-year revenue and modest earnings-per-share growth expected in fiscal 2002, we believe there is additional downside in the shares and limited positive catalysts in the near term," wrote Prudential analyst Ellen Chae, who made the aforementioned cut to Solectron's rating.

Last week, rival Molex cut third-quarter estimates by 2 to 5 cents because of a slowdown in PC sales. Like KLA, Molex put its 2001 numbers at the high end of its $1.40 per-share earnings estimate only to revise that later.

It was only a few months ago when manufacturing service providers were supposed to be a choice alternative to a stumbling technology market. The thinking was that in a slowing spending environment, these guys would benefit from cost-cutting initiatives like outsourcing. It had happened before, with tech companies choosing to have parts made elsewhere instead of incurring the cost of new factories and machinery needed to produce new parts.

But February's storm of tech warnings chilled a market warmed by a pair of Federal Reserve cuts to interest rates, which made money cheaper and should entice companies to spend again. The market stumbled and Dell (DELL Quote), Hewlett-Packard (HWP Quote), Intel (INTC Quote), Nortel (NT Quote), Cisco (CSCO Quote) and Ericsson (ERICY Quote) all warned. With the big guns jammed by a slowing economy, there is less ammunition to feed the bottom line at equipment makers.

"Customers' lack of visibility continues to accelerate the turn to outsourcing," Hassenberg wrote, saying that the picture may not improve in the near term, but could rebound over the next 12 to 18 months. "However, a slowdown in customer demand has an immediate effect on profits and losses."

In January, Flextronics signed a huge contract with Ericsson to provide more handsets. But as handset sales miss targets, that could be affected. The company already provides services for Dell, another company that's warned lately. No one is safe from the slowdown. Celestica provides services for Nortel and Hewlett-Packard. Solectron feeds Nortel, Cisco and Ericsson. Jabil Circuit does business with Dell and Hewlett-Packard.

And Monday, Piper Jaffray's Ashok Kumar said that the tech recession could last for most of 2001, with no sustainable recovery happening until the first half of 2002, casting a pall over not only Intel, the company he was writing about, but the whole tech world.

Money has grown tight across the board, so tight that outsourcing might not even be necessary, not with that glut of new and used inventory on shelves.