Description

We believe Jabil is a classic case of investors capitalizing a hiccup in earnings at an overly punitive rate.  The market currently perceives Jabil as having consistently disappointed investors over the past year and as likely to do so in the future, given the limited visibility of their business, their exposure to several large consumer electronics & networking customers with questionable futures, and recent weakness in the business with their largest customer.  Further, recent results are very messy due to a recent acquisition, recent divestiture, and a short-term issue which is causing Jabil to temporarily carry excess cost without accompanying revenue.  Due to these issues, the stock currently trades at 4.7x our conservative estimate of Pro Forma EBITDA, but a much less attractive 6.2x run-rate EBITDA guidance.  We see multiple catalysts over the next 3-9 months that are likely to return EBITDA closer to, if not above our Pro Forma estimates, as the issues currently depressing earnings will abate.  We also have a fundamentally different opinion on the quality of the business, and believe that about 37% of Jabil’s EBITDA comes from healthy, predictable, and growing end-markets that in standalone companies are valued at 8-10x EBITDA, and only 63% is subject to the volatility that recently has impacted results and tends to attract lower multiples.  Further, we fundamentally believe that the more volatile part of the business is higher quality than the market is giving credit for.  Taken altogether, we believe we can buy a collection of average to above average businesses at a very low valuation on an absolute and relative basis.  In the meantime, Jabil is generating a 11.5% free cash flow yield while we wait for our catalysts to play out.

What they do:

Jabil is a contract manufacturer that provides Electronic Manufacturing Services (EMS), which means that they operate as an outsourced manufacturing firm for Original Equipment Manufacturers (OEMs) in the electronics, consumer, healthcare and other industries.  Many of the branded consumer electronics products that we use on a day to day basis such as iPhones, laptop computers and televisions are manufactured by Jabil and other large contract manufacturers who use their incredible scale in order to procure components and manufacture products at the lowest possible cost. Large OEMs such as Apple or Sony, as well as nearly all small, upstart firms, find that it is more efficient to outsource the manufacture of their products to companies like Jabil in order to leverage their scale and reduce costs.  Contract manufacturers operate enormous manufacturing facilities all over the world in geographies that typically have low labor and operating costs.

Jabil breaks out their business into three segments (DMS, E&I, HVS), but we find it easier to think about the business through our own breakout.

Traditional EMS business (56% of Pro Forma Revenues, 41% of EBITDA):

This is the business most people think of when they think of Jabil, and is composed Jabil’s E&I and HVS segments.  It’s a relatively low margin, scale business of assembling consumer electronics & networking equipment.  The business is characterized by short product cycles, high volumes, and a limited number of SKUs, or “high velocity, low mix” business.  In addition to assembling the device, Jabil also uses their scale to procure the bill of materials often at a cheaper price than their customers could on their own.  We believe this is a mediocre, lumpy, and competitive business, but one that is better than most people give credit for, and that has generated nice cashflow historically.  We value this business in various scenarios from 3.5-4.5x EBITDA. 

Healthcare &Industrial EMS + Packaging (24% of revenues, 37% of EBITDA):

These businesses are Jabil’s highest quality and most valuable assets and are accounted for in their DMS segment.  Jabil’s main competitor in this segment, Plexus, trades at nearly 9x EBITDA.  Benchmark Electronics, who has about half their business in these segments, and half in traditional EMS, trades at 7x EBITDA.  These companies tend to trade at higher multiples because this is perceived to be a better business than traditional EMS, with the main difference being the end-markets.  These businesses are “low volume, high mix”.  They require more line changes and more stringent testing, certification, and design work (all of which tends to lead to higher margin), as compared to traditional EMS where a larger part of revenue is just a mark-up on the bill of materials.  Many of these products, especially class 2 and class 3 medical devices, need to go through stringent quality tests and must receive FDA approval.    Quality tends to be as, if not more important than price, and if you win business you tend to keep it for 7-10 years, compared to traditional EMS where product cycles are much shorter and unpredictable.  Jabil also recently acquired Nypro, which has a small rigid plastics packaging business that produces plastic packaging for consumer products, in additional to EMS for medical device and industrial customers.  The best comparable for Nypro’s packaging business is Berry Plastics, which trades at 8.5x EBITDA.  To be conservative, we value these businesses below comparables, at valuations between 6.5-8x EBITDA.  As a sanity check, Jabil recently purchased Nypro at the high end of this valuation range, and also divested a segment of this business for about 7.5x EBITDA.

Material Technologies (20% of revenues,  22% of EBITDA):

Jabil produces chassis, backplane assemblies, and specialized metal and plastic molded pieces for use primarily in cellphones.  For example, if you have an iPhone 4, 4S, or 5, Jabil was the manufacturer of the metal band around the phone, the SIM card enclosure, the volume buttons, and the internal structural components and backplane that house the phone’s electronics.  They also made the same components, but out of plastic, for the 5C.  This business is different from the traditional EMS business in that Jabil is actually fabricating specialized components, rather than procuring and assembling components made by other companies.  We believe there are a very limited number of companies globally that can manufacture these components (especially in metal) to the tolerance requirements.  These include Jabil, Foxconn, and Catcher, and to a lesser degree Casetek, Quanta Computer, and Flextronics.  Historically, since the iPhone 4, Apple has primarily relied upon Jabil & Foxconn to produce these parts for the iPhone.  We believe about 80% of this segment historically has been geared towards serving Apple, of which about half is related to backplane assemblies for the iPhones.  Although we actually think this is a decent business and Jabil has some very unique capabilities in this area that could likely be ported to another customer if Apple went away at some point, for conservatism’s sake we assume these businesses are as bad as most other investors perceive them to be, and only ascribe a 3.5x-4.5x multiple to them.

Why the stock is Cheap(er) than it usually is

Depending on what you think of the quality of these businesses, the whole EMS sector is cheap.  We aren’t making a bet on that perception changing anytime soon.  Not long ago, Jabil was trading at about 5.5x EBITDA.  Today, it trades at less than 4.5x our base case EBITDA estimates.  Our base case is predicated on the two below issues partially (but not fully) resolving themselves in the next 3-9 months, and the stock re-rating to its recent historical multiple.  Although we think there are very reasonable scenarios where both EBITDA and the re-rating exceed our expectations, we think at this price we don’t need to make that bet to have a nice risk adjusted return and IRR.

Concern #1:  Jabil’s top customers read like a who’s who of big tech with structural issues (Cisco, HP, Blackberry) – customer disengagements, like the recent Blackberry disengagement, are likely to continue.

Our View:  Jabil helps many of the world’s up and coming and established companies manufacture electronic products so they can focus 100% on design and marketing.  Jabil has an excellent reputation in the industry and has a history of manufacturing products for the hot company of the moment, whoever that happens to be.  As long as companies continue to invent more electronic gadgets that people want to buy, Jabil will build their share, although the customers will change as the hot companies and hot products change (e.g. Jabil makes the Google Glass).  This inherent creation and destruction in their end market creates some volatility in the business that results in buying opportunities, but is not a sign of the risk of structural decline – conversely, it is exactly the reason why this industry has and will continue to grow.

Late last year, Jabil announced that they were voluntarily disengaging from producing product for Blackberry, a 12% customer at the time.   This was the first leg down from Jabil being seen as one of the premier EMS companies by investors to one of the laggards.  The Blackberry business, all of which is reported in their HVS segment, will begin to materially come out of revenues this upcoming quarter.  Ultimately, we expect Jabil to be able to replace the Blackberry business with the companies that have taken share from Blackberry, as they have time and time again throughout their history.   Past significant customers of Jabil include:  Nokia (21% of revs in 2006, 12% in 2007, much less than 10% today), Phillips Electronics (18% 2004, 14% 2005, 12% 2006), as well as Quantum (tape storage).  The list goes on – suffice to say, Jabil has had multiple large customers over time, many of whom have gone the way of Blackberry in the past. Their largest customers are a reflection of the largest electronics companies of the moment.   And, as often happens with technology, what is big one year isn’t big a couple years later, so the major customers change.  But over time the number of electronic devices owned by consumers and businesses have increased, and thus so has Jabil’s customer list and overall revenue, while within that growth there have been former versions of Blackberry that have come and went. 

As an example of this dynamic, Jabil makes the Google Glass, and in general is building out capabilities to build “wearables” and products that fit into the “internet of things”.  The business exists because many electronics companies see benefits in outsourcing the procurement of parts and production of their electronic devices – this desire is not tied to a specific product or product category.

Jabil’s two plants that produced Blackberry product, in Hungary and Mexico, are two of their best plants.  They have already started to replace the Blackberry business, but this takes time.  In our base case, we assume they will be able to replace about 40% of the Blackberry business with other customers by the end of 2014.

Concern #2:  Jabil’s next quarter or two are likely to be poor, driven largely by an issue they’ve encountered with Apple.  Jabil has been very opaque as to what happened here.  How do investors know the relationship with Apple is still solid and how can we be comfortable that it will continue? 

Our View:  Based on our independent research, we believe the relationship between Jabil & Apple is very strong, and that weakness with Apple is entirely due to them being over-indexed to the Iphone 5C, which was a flop relative to expectations.  We believe Jabil is one of 3-4 companies in the world that can produce chassis and backplane assemblies to Apple’s specifications for iPhones.  We expect Apple to “make it up” to Jabil on the iPhone 6.

In mid-December, Jabil’s Q2 guidance sent the stock price down considerably, when they announced that a “demand issue” with a large customer would create a temporary steep decline in revenues.  Rather than drastically reduce expense in the effected facilities, Jabil stated that they are keeping many of the employees and infrastructure in place for this customer, which will result in similar expense levels on temporarily lower revenues.  Frustrated analysts asked many questions on Jabil’s earnings call, and the company was vague, only saying they are confident that this will be a 1-2 quarter issue.  Analyst earnings estimates declined from $2.39 a share to $1.10 a share for the current fiscal year. Most analysts and investors following the stock have “moved to the sidelines” pending further visibility and improvement in the business.  The only customer at question that is of the size to cause this issue is Apple.  Everyone knew that, but the company can’t comment on public conference calls on demand for Apple products – at least one supplier did this in the mid 2000s and was summarily dismissed by Apple shortly thereafter.  We believe the combination of two disappointments back to back, as well as an information vacuum surrounding Jabil’s relationship with Apple, creates the current opportunity in Jabil.

It’s pretty clear what happened with Apple and, in retrospect, it’s a bit surprising to us that this news came as a shock to analysts and investors.  In short, as early as March 2013, it was reported that Jabil was the lead supplier of the plastic chassis and backplane assemblies for the iPhone 5C, while having very little exposure to the 5S (although we’ve heard suggestions that they may be a back-up supplier).  See:  http://appleinsider.com/articles/13/03/15/apples-budget-iphone-expected-to-have-same-4-inch-display-as-iphone-5

The 5S is outselling the 5C at least 3:1, whereas Apple had expected a more even split.  This too, was widely reported on as early as October, as Foxconn & Pegatron (who were the primary EMS vendors for the 5C & 5S) noted Apple was cutting orders for the 5C and wanting more 5S:

http://blogs.wsj.com/digits/2013/10/16/pegatron-outlook-murkier-as-apple-cuts-iphone-5c-orders/

A couple months later, one week before Christmas, Jabil gave poor earnings guidance, which was the natural consequence of being the lead supplier on a product that has underperformed Apple’s expectations.  But because most investors didn’t know Jabil was heavily reliant on the iPhone 5C, it came as a surprise, and the stock was slammed that day and remains depressed.

Apple is arguably the best covered company in the world – there is a cottage industry that tries to figure out what the new iPhone will look like and who will be the suppliers.  While we can’t be certain Jabil will see its business with Apple rebound, we’d make a few points that suggest that this is the most likely scenario.

1)       The company, both on their latest conference call and in private, has been adamant that this is a couple quarter issue.  As support for that, they have specifically kept a tremendous amount of personnel that it would make sense for them to layoff if that business wasn’t coming back.  Our understanding is that this would be consistent with needing to run production tests on a new iPhone model, which could ramp as early as April. The company clearly thinks they are getting demand back, whether it is through the iPhone 6, the 5S, iWatch, or some other product in the Apple pipeline.

2)      Both Jabil and people in industry blame Jabil’s weakness with Apple entirely on 5C demand, not on any manufacturing issues with Jabil.  Although this is possible, we’ve talked to many people in industry and not heard of this occurring.  To the contrary, our understanding is that Jabil has the best yields for Apple of any of their iPhone chassis and backplane suppliers.  We’d also note that Jabil was a secondary supplier on the 4, 4S, and 5.  With the 5C they were given the lead position, which speaks to Apple’s confidence in Jabil’s ability to produce.  It just so happens that the product they were attached to was not successful. 

3)      Apple tends to stick with suppliers they’ve worked with in the past – they tend not to send out wide RFPs – they are obsessive about both secrecy and quality.  The engineering and process sophistication that goes into making an iPhone is extreme.  As example, for a cheap Dell laptop, the “tolerance” of how the components are engineered has to be within 1mm of specs.  For the iPhone, it is often .1mm or less – if the supplier doesn’t make each part to within .1mm of the specifications, then the part must be scrapped.  The percentage of product that meets specification is referred to as “yield”. The tooling & expertise required to produce millions of engineered components to that tolerance level on Apple type volumes is not something many companies possess, and is one of the reasons that Apple products are often delayed or encounter supply shortages (e.g. as happened on the Iphone 5S, and as is rumored to be happening on the iWatch).  A supplier like Jabil who has worked on the iPhone for several years, and who can deliver better yields than someone fresh off the sidewalk, delivers real value to Apple and makes it unlikely Apple will leave them.  Also, unlike many other Apple suppliers – who must have the latest and greatest technology to continue to remain on the iPhone – the part of the phone that Jabil builds is structural, and tends to change less frequently and is less prone to the technology risk.

4)      We have heard suggestions that Jabil may be shifting some of the capacity from the weaker selling 5C to the better selling 5S, which would improve their sales with Apple.  There is also the possibility that the 5C, after launching with China Mobile or after an inevitable price decrease, could sell better and lead to an increase in production of the 5C.  We aren’t relying on either of these outcomes, but they are other ways for Jabil to make up some of the business they lost on the 5C.

5)      Even if Jabil lost their iPhone business with Apple, one would think many other potential customers craving Apple type quality would be eager to step in and replace Apple, although this would take time.  Further, Jabil makes other components for Apple (plastic keys, the plastic casing & dongles on many apple accessories, etc.) so there is a solid base of business for Jabil with Apple even if they are not selected to produce engineered chassis and backplane parts for the iPhone 6.

Valuation:

We have contemplated three potential investment scenarios. 

Bear Case:  Jabil does not replace Blackberry or the Apple 5C to any meaningful degree nor do they reduce costs.  We run-rate the midpoint of Jabil’s Q2 EBITDA guidance and assume that the business stays at this level. We add in 1 year of cash flow and apply what we believe are very conservative multiples, and arrive at a stock price not far off from where we are today. 

Base Case:  Here, we assume Jabil only recovers about 75% of their prior level of Materials business and recovers 40% of their Blackberry business by 2014.  We also assume modest growth in the HC/Industrial/Nypro business.

Bull Case:  Here, we assume Jabil recoups about 2/3rds of the lost Blackberry business and all the lost Apple business in CY14.

Risks:

**Jabil loses Apple or another one of their large customers, due to execution issues or product misses

**Jabil not awarded business on the Iphone 6

**Potential for bad Q2 and Q3 results as Jabil works to replace the lost Blackberry & 5C business

**Radically different change in form factor or materials on a future version of the iPhone that makes it more likely Apple switches chassis and backplane suppliers.  Also some risk that smartphones move more towards phablet sizes, in which case it is unclear if Jabil, Foxconn, or Catcher (who makes the backplane assemblies on the Ipads) gets that business.

Catalyst