EMS industry underestimated. Growth opportunities seen at numerous EMS companies. Sanmina-SCI in major identity makeover. Flextronics disproportionate beneficiary in computing. Clean tech aids non-traditional EMS sectors. OEMs reevaluate strategies.
Some believe the EMS industry is well positioned to demonstrate strong growth over the next couple years. Non-traditional EMS sectors such as industrial and medical electronics continue to be viewed as the stronger industry growth drivers also being aided by clean technology spending.
Investment bank Needham & Co. released a report on their views following discussions with thought leaders in the EMS industry. Conversations with those in EMS suggest the EMS environment is still in a positive recovery mode as also reflected in Wall Street estimates looking out the next 1 to 2 years (see Table 1).
Over the past few quarters and despite the new-found optimism, Needham believes Wall Street is still consistently underestimating the return of business to the top-line for EMS CEOs.
Meanwhile, Needham states in its report the bank remains of the view the recovery is not robust in absolute terms and some level of lower seasonal demand could be present for select segments in 2Q, and that the bank is becoming increasingly encouraged its conservative estimates are likely to move upward.
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The report goes on to state that in the big picture, the health of the EMS market is generally decent, and it is re-emerging as a perceived growth industry once again.
Table 1: Key EMS provider revenue forecast
Opinions from Needham’s industry discussions indicate multiple drivers to support the bank’s position: 1.) return to more normalized volumes from existing and legacy programs; 2.) improved contributions from nascent ramps and program wins over the past year (that had particularly low volumes in the cautious and challenged tech environment); and 3.) new programs outsourced to the industry
The Needham report emphasizes investors and others following the EMS sector that the third point is a crucial variable that allows the EMS industry to outgrow much of the broader tech hardware environment.
Needham further states it believes this is particularly the case today while many product industries are climbing out of a period that forced OEMs to reevaluate strategies and how manufacturing / supply chain management fits in the picture. Strategically for many OEMs, this would not be a focus for their core competencies.
EMS segment characteristics
As Needham looks at the EMS companies it covers in its universe, the bank breaks down segments to highlight those it anticipates to demonstrate above-average EMS industry growth (projected by IDC at 9.0% from 2009-2013).
According to research firm IDC (see Table 2), nontraditional spaces such as industrial and medical continue to be viewed as areas with stronger growth opportunities, and these are segments where outsourcing penetration remains very low and is often under 10% or even 5%.
Another high growth area is consumer electronics. While growth opportunities are strong, Needham’s report reminds readers and investors of the shorter product cycles and seasonal characteristics of such programs which also tend to be less sticky than other ‘non-traditional’ areas.
The main exception to the high growth and non-traditional market combination is computing (a more traditional space). Largely driven by notebooks, preference shifts today continue toward a mobile world and growth remains solid.
Needham expects Flextronics to continue as a disproportionate beneficiary of the growth in computing (in its nascent notebook efforts). Further, one of the main reasons we have a favorable view of Flextronics is due to the magnitude of growth it is seeing in computing (which Needham believes is presently outweighing the drawbacks of lower margins for this particular area of business).
Table 2: IDC Forecast of EMS segment opportunities, growth 2009 to 2013
Neehham profiles the segment exposure according to most recent reports for each of the EMS companies the investment bank covers. The bank’s report also highlight the EMS companies (Benchmark Electronics, Jabil Circuit and Plexus) that have strong exposure (30%+) to the higher growth segments where programs tend to have greater overall stickiness.
While Jabil just made the cut at 31%, Needham states in its report that Jabil’s November quarter mix was biased toward greater consumer products (and thus ‘non-traditional’ is often a larger relative component).
Operating margins
Reporting within the thin-margin EMS industry does not always allow for simple ‘apples-to-apples’ comparison as many companies focus on excluding options performance while others include options.
Often, the margin profile is dominated by the mix of business and volume orientation.
Today, many companies are operating below their target (or, in Sanmina-SCI’s case, a new target) margin profile, which Needham has profiled in Table 4 on an ex options basis.
With most of the EMS companies Needham follows delivering contribution margins in the 10% to 15% range at the gross level (as revenue leverage and capacity utilization improves), the investment bank states in its report it believes operating margins should continue to expand and near (if not exceed) corporate goals in the next 6 to 12 months.
The report states further Needham believes the one exception to this timeframe is Sanmina-SCI, which should not be construed as a negative view.
Rather, Sanmina-SCI remains in the midst of a major identity makeover that is expected to take time.
Sanmina-SCI has shed much of its volume / commoditized programs (i.e., PCs) and aims to capitalize on its vertical model and component investments to push its operating margins to the 6%+ level (which Sanmina-SCI has not seen since early 2001).
Table 3: Key EMS provider operating margins
EMS earnings outlook, valuations
Looking at earnings estimates, Needham and Wall Street both seem to say a strong rebound could be in store for the EMS industry this calendar year (see Table 4).
Needham mentions in their report the firm often takes a conservative approach to its estimates, and further upward revisions appear increasingly likely as long as the macro environment continues to recover and leverage flows through the EMS company models.
Needham feels Plexus and Benchmark (16x and 17x C10) garner better valuations due to strong revenue outlooks, the mix of their business, and stronger operating margins (at present).
Both Plexus and Benchmark also have healthy balance sheets with $2.15 and $6.96 in net cash per share, respectively.
In a growth period where Jabil is executing and it is getting reasonable leverage from its Green Point business, Needham feels Jabil should trade near 15x+ considering its mix and margin profile.
Flextronics garners the lowest valuation in the EMS universe Needham covers due largely to the company’s size and lower-margin profile. Consequently, Needham feels the ability to move estimates upward in an improving environment is not as dramatic as other companies in the space.
Sanmina-SCI appears to be trading at a healthy valuation (and while considering its $6.63 in net debt per share), but Needham feels its forward estimates could be fairly low if the company continues to execute during its transformation re-build.
Meanwhile, the ‘credibility factor’ from years of past missteps continues to weigh on sentiments and has led to a very wide range of expectations from various analysts for overall performance and earnings generation. To date, Needham feels Sanmina-SCI has made fantastic progress in improving its margin profile aided in part by addressing issues in its components group, which is still underperforming but improving.
Driving revenue through these vertical investments and improving margins will be important for Sanmina-SCI to continue executing and make its 6%+ goal achievable.
Not only will earnings improve for Sanmina-SCI, but improved margins should allow the company’s multiple to expand closer to Plexus and Benchmark (vs. Flextronics) on a more sustainable and longer-term basis.
Table 4: Key EMS provides earnings outlook
Source: Needham & Co., IDC, VentureOutsource.com
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