Is Jabil Quietly Loading Both Barrels?

By Stephen D. Simpson, CFA | September 30, 2011 AAA

Investors should be careful to place only a very few stocks in the "permanently uninvestable" box. Typically this is reserved for companies where management is untrustworthy, the business is in inexorable decline or the cyclicality is just too much to bear. While I confess to being quite hard on Jabil Circuit (NYSE:JBL) in the past and very nearly putting it in that dreaded box, this company may actually be shaping up as an interesting play for the next few years.

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A Solid Close to the Year
Part of my skepticism on Jabil has been based on the company's customer list. Right now, if you rely on Cisco (Nasdaq:CSCO), Research In Motion (Nasdaq:RIMM) and NetApp (Nasdaq:NTAP) for meaningful revenue dollars, you cannot be feeling too good. And yet, Jabil managed to post a very solid quarter all the same - testament, perhaps, to the company's diversity of clients and markets.

Revenue rose 11% from last year and about 1% from the May quarter. Growth was led by the Diversified Manufacturing Services segment, the company's catch-all for less traditional EMS markets like healthcare and clean tech, where sales rose more than 34% and were the largest single contributor. Revenue was down nearly 9% in the High Velocity business, while up almost 8% in the Enterprise/Infrastructure segment - the latter two being where customers like RIMM, Cisco, Nokia (NYSE:NOK) and Hewlett-Packard (NYSE:HPQ) live.

Profitability was solid by almost any measure. Gross margin at EMS companies is typically very slim and so it is here, though the company did improve 30 basis points annually and 20 points sequentially. Operating income was up 45% on an adjusted GAAP basis and up about 19% on a non-GAAP basis. The big difference is largely attributable to a major drop in share compensation expense, but either way the razor-thin operating margin did improve. (For related reading on operating income, see Analyzing Operating Margins.)

Diversification
One of the more important bull theses on Jabil revolves around its effort to diversify away from traditional EMS markets and into growth opportunities like healthcare, energy and clean tech. So far, that's working (as witnessed by the sizable revenue growth this quarter), even as the contribution from healthcare is well below the long-term target and boasts relatively few major clients (though well-known ones like General Electric (NYSE:GE) and Johnson & Johnson (NYSE:JNJ)).

Simply put, the bet here is that healthcare companies are going to realize what tech companies figured out long ago - their "secret sauce" lies in product development and marketing, not manufacturing. Sure, some companies are good at it or have such specialized needs they won't outsource, but there's a huge range of medical devices and products that lend themselves fairly easily to outsourced manufacturing.

Recovery
Jabil is doing pretty darn well in a fairly tough tech hardware market. On the consumer side, not much is selling that doesn't have the Apple (Nasdaq:AAPL) logo on it (and Apple is reportedly a Jabil customer). Likewise, companies like Juniper (Nasdaq:JNPR), Cisco and Hewlett-Packard are more the rule in enterprise hardware and companies like IBM (NYSE:IBM) and EMC (NYSE:EMC) more the exception.

Barring another dive into recession (and a prolonged one at that), the IT market should recover over the next year or so. True, maybe companies did binge a bit on their IT needs as the recovery took hold, but that spending should nevertheless come back. When it does, Jabil (as well as rivals like Flextronics (Nasdaq:FLEX), Celestica (NYSE:CLS) and Foxconn will be ready and should see a rebound in sales.

The Bottom Line
One of the tricky parts in modeling Jabil's cash flow and creating a fair value estimate is that relatively tiny changes in margin assumptions have huge impacts on the final result. Just a 25 basis point change in year five free cash flow margin, for instance, means more than $50 million in incremental free cash flow and nearly $3 in stock fair value. (Free cash flow is a great gauge of corporate health, but it's not immune to accounting trickery. For more, see Free Cash Flow: Free, But Not Always Easy.)

Even with that note of caution, these shares look too cheap right now. Sure, another wash-out recession will likely drive valuation even lower, but that's a risk present in almost any operating company today with exposure to North America. If Jabil can continue to execute on its plan to grow non-traditional EMS markets and maintain a diverse business base in more traditional markets, this could be a powerful one-two recovery punch for the next 12 to 24 months.

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