2011 EMS industry perspective reveals risks for Flextronics, Sanmina-SCI, Jabil Circuit, Benchmark Electronics, Plexus. 2010 program wins can take 12 to 18 months to ramp. Possible return to M&A across EMS sector. Increased focus on non-traditional EMS markets. Overall 2010 YTD performance lags notably due to magnitude of mid-2010 decline.
As 2010 concludes, according to a new report released by investment bank Needham & Co., inventories have largely been replenished, the supply chain has been righted, and the recovery from underlying growth markets has subsided.
Many in the electronics product manufacture and design supply chain have experienced a notable rebound in revenues and higher quality earnings (on leverage of cost-optimized operations).
However, on an encouraging note, Needham argues the positive tail-winds in the electronics manufacturing services (EMS) industry are not done.
Most importantly, the report cites the rising tide environment is still in effect as the bank expects a surge of business activity and newly outsourced programs from late ’09 / early ’10 to provide a healthy boost to C11 (a dynamic Needham feels many investors have still not fully recognized).
Below is select commentary from that report, including both industry trends as well as sentiments the bank believes are tied to improving market conditions.
Current electronics supply chain / EMS environment healthy, stable
Following the inventory replenishment activities that lasted into 3Q10, Needham believes that underlying markets are healthy (albeit not robust for most segments), that the component supply chain is largely recovered and continues to improve / ease, and that customer forecasts have been quite stable (reducing supply chain and operational volatility/ improving operational efficiency)
Needham looks forward in 2011
As the bank looks to 2011, Needham & Co. goes on the record believing the general EMS business is likely to experience continued positive tail-winds.
Specifically, Needham expects: (1) recent wins and newly outsourced programs to contribute a larger relative level of y/y growth; (2) increased focus on non-traditional markets; (3) a healthy operating and earnings environment; (4) greater distinction between high quality and executing management teams; (5) some return of M&A in the EMS industry; and (6) multiple expansion activities across the group.
Sometimes the key to an outsourcing business IS outsourcing
“Essentially all of EMS (and the supply chain) experienced strong tail-winds as a consequence of recovering end markets entering 2010”, says Needham’s Sean Hannan.
But, in the background, Needham believes a ‘second part’ (Act II) to the rising tide dynamic had been building through a surge of new business activity at OEMs (who were truly pressured to optimize their own operating models) across multiple industries.
Since many programs can take 12 to 18 months to ramp, Needham believes major EMS providers are now very well positioned (and exhibiting high confidence) for C11 with the opportunity to demonstrate solid double-digit growth.
Investment perspective
Overall, Needham prefers companies in its universe coverage with strong growth profiles (already forecasted to exceed 10%) in addition to a favorable end-market and product mix focus.
Presently, Needham believes programs at Plexus put that EMS provider in the leadership position in terms of mix while Needham believes Jabil Circuit is positioned to gain the most ground as it builds its non-traditional business from 34% to ~50% in the next 4+/- years.
Needham’s 2010 review
In the December 22, 2010 report, Needham states the beginning of 2010 started off with plenty of optimism for electronics supply chain participants as the global recovery (or, ‘bounce’) was underway; lead times were stretched at component providers, inventories at OEMs remained low, product demand was often unmet, and companies continued to revise forecasts upward.
Derivatively, Needham stated much of the universe of EMS providers the bank covers reflected the favorable conditions early in 2010 as performance for four of five of the EMS providers Needham covers tracked or exceeded the performance of the Nasdaq.
In short, the space (which can tend to run earlier than the rest of the tech sector) was red hot in Needham’s eyes until exogenous and macro concerns began to weigh on sentiments, starting in late April 2010.
By April 27th, Standard &Poor’s cut the sovereign debt ratings of Greece to junk and Portugal was also lowered.
The bank believes investors’ sentiments turned toward the reality that inventory replenishment would ultimately end while a slow growth environment (if not a double-dip recession) was becoming a concern on the horizon.
Realism soon became pessimism as the market pulled back, volumes waned, and the high-beta EMS names experienced a precipitous decline through the remainder of the spring and through the end of August.
Then, beginning in September, volumes and some level of optimism began to return while fears of a double-dip moved to the background.
While EMS providers have performed better than the broader market in the back end of 2010, overall YTD performance still lags notably due to the magnitude of the spring/summer decline.
Spare parts
As noted in the report, the big topic of component constraints certainly limited revenues and artificially inflated inventories (with final shipments sometimes delayed due to a single component).
On a positive note, Needham states inventories never really got out of hand and are generally working down the last couple quarters relative to sales (other than Plexus with its Coca-Cola program and Jabil Circuit with other new business ramps).
But, perhaps the most important benefit of the tight supply chain in the tech sector was the ‘gating effect’, which Needham believes forced tighter forecasting, planning, and communication between electronics OEM decision-makers and the supply chain (ultimately reducing risks of artificially high / unsustainable order peaks).
Healthy operating environment
During the tail end of Act I of the ‘recovery’, EMS providers continued to drive margin expansion, with mix having differing impacts on contribution margin as revenue returned.
By mid-summer, order volatility declined and forecasts generally stabilized; Needham believes this dynamic has remained in place through early December.
While not all EMS providers are seeing revenues above 2007 / ’08 levels (only Plexus and Jabil Circuit, among the EMS providers Needham covers), business has been healthy most of the year and some geographic facility expansion has resumed.
Tier 1 EMS struggles
For EMS providers with vertically integrated models such as Flextronics and Sanmina-SCI, component revenue absorption continues to be a notable obstacle to achieving target margins, but bookings and sales have headed in the right direction.
The enterprise environment has been somewhat stable while very near-term company-specific guidance has been spotty (although not problematic); as always, Needham believes, investors place (perhaps too much) emphasis on the read-through of OEM guidance (i.e., negative sentiments following Cisco) and the interpretation for the health of EMS prospects was probably overdone.
In general, Needham believes the business make-up at many of the EMS providers it covers is vastly improved versus a few years ago, and diversification across customers as well as segments has set the stage for a respectable December quarter.
Needham goes on to say it the report the bank believes the absence of a strong sequential uptick in December reflects conservatism in the markets as well as a practical approach at OEMs with component tightness continuing to ease and inventories at more healthy levels.
Setting the stage for Act II, outsourcing utilization by OEMs
Many investors duly welcomed the return of revenues that drove recovery hopes earlier in the year. However, the bank believes the building story behind the scenes that is less tangible (but no less meaningful) to investors is the surge in business development and new outsourcing over the last 12 to 18 months.
Fueled by refined or evolving strategies as OEMs climbing out of the economic meltdown, outsourcing has received a booster shot.
Particularly for OEMs or industries that have not utilized an outsourced model, pressures have clearly intensified to reduce cost structures and move forward with optimized strategies.
The ‘Great Recession’ has forced changes, and OEMs continue to recognize that manufacturing is not as aligned to core strategic competencies as it once was.
Out-of-the-gate thoughts going into 2011
At the publishing of this report, Needham believes a solid year lies ahead for the banks entire EMS universe, and also believes the underlying business is healthier than the fears expressed by some of the more pessimistic, enterprise-tracking investors.
One of the most critical pieces to the 2011 picture Needham’s Hannan states is that recently won programs through late 2009 and early 2010 that should allow many EMS players to continue its double digit growth (albeit at less than stratospheric levels).
Specifically fueling this growth should be non-traditional markets such as industrial electronics, commercial and medical electronics.
IDC EMS industry forecast by segment
With what Needham believes as most underlying markets being generally stable and a surge in recently won programs likely to benefit leading EMS providers as well as the rest of the EMS industry (recall it can take 12 to 18 months to ramp new business from 2009 / ‘10), Needham believes all of its covered EMS providers are well positioned for double-digit revenue growth in C11.
2011 dynamics perceived to play out
Specifically in 2011, Needham’s report states the bank expects the following dynamics to ultimately materialize:
Recent wins and newly outsourced programs will contribute a larger relative level of y/y growth (versus simple end-market demand) as non- traditional segments outshine “enterprise”.
Double digit revenue growth for most major players (although clearly tempered versus the enormous resurgence in 2010).
Increased focus on non-traditional markets, with strategies further pursuing higher margin and sticky program niches while de-emphasizing “middle of the road” margin (and somewhat lower complexity) programs.
Operating and earnings environment will be healthy, but margin expansion will be marginal (at best) across most players. Those positioned to see better margin expansion are companies with vertical models (still awaiting volume) such as Flextronics and Sanmina-SCI.
Distinction of high quality management will become more apparent with the recovery bounce now behind while strategy and operational execution move to forefront.
Return of mergers and acquisition in the EMS sector in the form of technical capabilities or strategic market competencies (Needham notes it does not expect mega-deals).
Multiple expansion from restored confidence, above average tech growth, and further execution toward model/target goals.
Closing remarks and EMS provider-specific risks
Apart from general economic conditions, Needham’s Hannan ends the bank’s research report stating some EMS provider-specific risks that follow:
Benchmark Electronics
Benchmark Electronics risks include, but are not limited to: 1) stronger than anticipated weakness in end market demand; 2) loss or decreased orders from Oracle or any other major customer; 3) inability to improve gross margins or utilization due to difficulty ramping new or existing programs; 4) and substantial acceleration of ‘end-of-life’ programs at customers.
Jabil Circuit
Jabil Circuit risks include, but are not limited to: 1) Jabil’s relatively high exposure to the consumer electronics market, which may be difficult to offset if the overall market weakens; 2) potential loss or decreased orders from a major customer (i.e., renegotiating contracts); 3) inability to improve gross margins or utilization due to difficulty ramping new or existing programs; 4) pricing pressure in an ultra-competitive industry.
Flextronics
Flextronics risks include, but are not limited to: 1) significant incremental downturns in end-market demand; 2) the inability of new program ramps to offset declining legacy volumes; 3) a notable loss or impairment of a top-10 customer; 4) significant challenges in its ODM notebook / computing efforts plus, 5) readers should also be on the lookout for any impending / potential fallout from the recent Federal government probe of confidential customer information for one of Flextronics’ customers (Apple) being released to Wall Street by a former Flextronics manager.
Plexus
Plexus risks include, but are not limited to: 1) customer concentration (i.e., Juniper Networks); 2) successful ramps associated with its nascent Coca-Cola relationship 3) effective leveraging the company’s significant investment in operating expenses (relative to their peers); and 4) maintaining sufficient differentiation relative to top-tier EMS players seeking to expand engineering services.
Sanmina-SCI
Sanmina-SCI risks include, but are not limited to: 1) significant downturns in end-market demand; 2) the poor offsets of new program ramps during periods of declining legacy volumes; 3) the loss or impairment of a top-10 customer; and 4) significant challenges improving utilization of its vertical investments in components.
Source: Needham & Co., VentureOutsource.com
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