Can Jabil Successfully Transform its Business?

 Jabil Circuit (JBL) has been gaining market share at the expense of competitors during the last couple years, especially in the higher-margin industrial/instrumentation and medical spaces. This is consistent with the company's strategic goal of moving a larger portion of its business into higher-margin verticals, something it spelled out in considerable detail less than two weeks ago. However, we feel the difficult industry dynamics of contract manufacturing will eventually undo any increases in profitability that occur in the near-term.

During fiscal 2010, Jabil was able to grow industrial/instrumentation and medical sales 44% year-over-year, to $3 billion. These verticals comprise roughly half of the company's diversified manufacturing services, or DMS, group, which also includes clean technology, defense/aerospace, and aftermarket services. Comprising 36% of total sales, management has stated its intention to grow this area of its business to 50% of revenue. The rationale for such a strategy makes sense: The high operating margins in this area--which were 6% in fiscal 2010--currently drive more attractive returns on capital than are available in other areas of contract manufacturing.

However, we're skeptical about the sustainability of Jabil's recent success in growing share. This view is clearly at odds with the company's expectation that it can grow its DMS unit by 20%-30%, and generate strong returns on capital over the long term. The reality is that contract manufacturing has no barriers to entry, even in high-end production/manufacturing. We suspect that competitors will begin to copy Jabil's strategy, and place increasing emphasis on these same verticals as well, inevitably creating more competition in the higher-margin areas of contract manufacturing. As a result, we expect the returns in these areas will compress in future years, and we doubt Jabil will be able to generate sustainably higher returns on invested capital from its current strategy.