2009 EMS outlook: Wall Street electronics manufacturing services analysis
As investment bank Needham & Co., LLC looks to 2009, the bank believes economic disruption should magnify difference between strong and weak electronics manufacturing services (EMS) companies. The bank’s universe of EMS companies it follows include: Benchmark Electronics, Flextronics, Jabil Circuit, Plexus and Sanmina-SCI.
In this report looking at what’s in store for 2009, Needham & Co. outlines a few key themes influencing EMS players in its universe:
- inventories
- capacity
- visibility and end-market exposure
- new outsourcing opportunities
- available cash
- raw materials
- viability
The investment bank believes most EMS companies it covers will be hard pressed to exhibit revenue growth in 2009. However, the bank comments to industry investors of the basic EMS value proposition: manufacturing and supply-chain prowess. Meanwhile, research firm IDC still expects EMS industry revenue growth in 2009, and believes larger opportunities remain longer-term.
As Needham & Co., attempts to layout its outlook for 2009 in the following pages, discussions the bank has had in industry suggest that visibility remains incredibly challenging and the first half of 2009 could exhibit lower revenues year / year near the double-digit range. Smaller pockets of support that may provide some buffer are likely to be within non-traditional EMS industry segments such as medical and industrial electronics or, from outsourced programs entirely new to the industry.
High-end computing; consumer electronics and infrastructure / networking appear positioned to remain particularly challenging. Most discussions in industry indicate that companies the bank follows have earmarked C2Q09 as the potential turning point with the back half of the year likely to be quite back-end weighted.
In consideration of the current environment, IDC recently forecasted the base case for 2009 global IT spending growth to be roughly 2.6% (down from ~4% to 5% growth in 2008), with the downside projected to be flattish.
Specific to the EMS sector, IDC currently projects revenues for the sector to improve 7.0% in 2009 (see table below). Of particular interest are a few potential double-digit growth sectors applicable to companies: industrial, medical and automotive (to a lesser degree).
While the investment bank does not believe all EMS companies in its universe of coverage will exhibit revenue growth in 2009, the bank does believe it is important for investors to remember the basis of the EMS value proposition: manufacturing and supply-chain prowess.
IDC EMS WW Revenue Projection (Billions $USD)
Of course, as end-markets decline, revenue results could be dragged down disproportionately in the near-term and the bank concedes its previously conservative estimates appear destined to be revised lower. However, larger opportunities remain longer-term (and potentially 2HC09) as OEMs across industries should arguably leverage outsourcing partnerships in order to focus on core strengths such as innovation / IP design and development, sales and branding.
With this in mind, below are expansions for each of the key themes noted previously, above.
Inventories
Regarding the EMS companies covered in this report, nearly all exited C3Q08 with higher inventory levels as a percentage of sales than the prior year but, lower than in 2006. Potential write-downs are a legitimate concern for the EMS industry; so, companies with a high concentration of established and diversified OEM customers (such as Plexus) could potentially run into fewer issues. In general, Needham & Co. expects the EMS industry to work with OEM customers to drive levels lower – which will take time.
Interestingly enough, some EMS programs with OEM customers (which fall under categories such as industrial) require high levels of inventories – at the request of customers. If the dynamic is maintained at the request of the OEM, such business would need to command margin premiums to compensate for the risk. Overall, the investment bank believes the metric requires further monitoring even though OEMs are accountable (technically), in most cases.
Capacity
If you built it, will they come? The bank believes the EMS industry entered the current environment with excess capacity, and industry capacity utilization levels are headed lower for at least the next 3 to 6 months. Additional layoffs also appear likely to materialize to some degree throughout the universe of EMS companies covered by Needham & Co.
In general though, the bank expects business for EMS providers with the most strategic footprint (on both a cost and market access standpoint) to be the most successful as OEMs continue to be increasingly selective in their partnerships. Further, with the recent cost increases in labor, currency movements and freight concerns, the ability to provide near-shore manufacturing (i.e., Mexico) is expected to generate increased interest.
The investment bank feels Flextronics appears to be in the driver’s seat with a flexible model located throughout many low-cost geographies following the rationalization of Solectron. Plexus (which recently shut down a facility in Ayer, Ma.) and Benchmark Electronics also appear to be on solid ground with current footprints when considering their mix of business.
On the other hand, Needham & Co. believes Sanmina’s hand is likely being forced to take more aggressive actions to improve its footprint within its components business (i.e., enclosures) and possibly more. During the interim, the bank states it is cautious on resulting pricing behavior, but does not believe any evidence has surfaced (yet).
Visibility and end-market exposure
One of the biggest issues on investors’ minds today is the sheer lack of visibility into future quarters. Not only are end-markets unpredictable, but OEM behavior such as precipitous inventory work-downs have magnified the impact. The investment bank expects this trend is likely to continue at least into early 2009 before improving.
Overall, companies such as Plexus, with a more non-traditional business of higher mix, lower volume (~44% of revenues from medical, instrumentation and defense / security in September 2008) are likely to be better suited to weather this recessionary environment.
New outsourcing opportunities
While end-markets will undeniably dictate the performance of the EMS sector in 2009, it is important for investors to remember that the OEM outsourcing rate is another source of growth that could provide a potential buffer to business (at least in the second half of 2009). Outside of unique circumstances such as the type of product or the timing of a recently outsourced program, Needham & Co. believes most OEMs are inappropriately suited to bring programs back in-house without significant costs.
Supporting this dynamic, one industry research firm recently projected roughly a 4.6% revenue growth premium for EMS companies above the broader electronics industry. Specific to Needham & Co.’s universe, the investment bank believes the entry of Flextronics into notebooks in 1Q
(such as HP’s Voodoo line) will have large impacts on overall results (this will take time to scale).
But, companies such as Plexus and Benchmark Electronics are well positioned entering the year with healthy business backlogs / new wins fueled in part by complementary engineering efforts (which the bank believes continued into C4Q).
Cash is king
Access to cash, and cash generation, will be crucial, particularly for the companies carrying net debt. As Needham & Co. expects investors continue to focus on debt burdens and covenants, the investment bank expects net cash companies such as Plexus and Benchmark to receive less scrutiny. Perhaps, more importantly, will be the ability to generate free cash.
In this vein, the bank feels companies such as Flextronics and Jabil are expected to ratchet down capital expenditures significantly while monetizing the balance sheet and working capital. Flextronics is also already in the process of reducing its debt (as exemplified by its Dutch tender for up to $250 million of its 1% convertible notes due 2010), which should improve its balance sheet and operating flexibility.
Materials relief?
Probably. The run-up in materials pricing (precious metals, petroleum-based products) has had some impact to margins for the better part of the last two years either directly or through increased pricing. The investment bank expects the pull back in demand to at least provide some temporary relief.
Viability
History dictates the EMS industry is not likely to exit with the same number of EMS players and that some consolidation should be expected. Heading into the current environment, Sanmina-SCI and Celestica (not covered by Needham & Co.) appear to be the leading candidates. But, there seems to be an absence of a clear potential acquirer. Separately, the bank stated it would not be surprised if Jabil becomes more aggressive in openly shopping its displays business, which has been a problem spot for the last 12 months due to struggles at its main customer (Philips) in Europe.
Source: Needham & Co., VentureOutsource.com, December 2008
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