Taking the pulse of EMS

Hello. This is my first contribution to VentureOutsource.com on the electronics manufacturing outsourcing market. In this space, from time to time, I will examine the trends, issues, customers, and providers in this US$238 billion market at the root of the modern electronics hardware industry.

My goal is to provide readers with insight into this market from an informed perspective and to generate discussion on topics to help inform; question assumptions; and hopefully generate new ideas about how electronics manufacturing services (EMS) providers and OEM customers interact and, how the industry evolves. You are each encouraged to pose questions or comments in the space provided at the base of this article.

In this first article, we look at the first part of 2007 and examine issues the leading North American EMS firms are facing. By taking into consideration mid-year quarterly conference call discussions with Celestica; Flextronics, Jabil Circuit, Plexus, Sanmina-SCI, and Solectron, we see the major themes that have been challenging the industry for the past several years and we look ahead to the next three to six months.

First, let’s start with a recap of the numbers in the table below. These six EMS companies generated a little over $31 billion in revenues during roughly the first half of 2007 translating to 12% more when compared to the first half of 2006.

Leading North American EMS providers first half 2007 results

The two largest EMS firms, Flextronics and Jabil, grew significantly while Solectron just barely beat the market. Plexus turned in a slight increase over 2006, performing well during the first quarter while suffering through the second.

Sanmina and Celestica both watched revenues decline during the first half of 2007, compared to 2006. So, for revenues, performance was mixed.

Profitability was a greater problem during the first half of 2007. While Flextronics just about held steady, compared to 2006, gross margin rates for the remaining EMS providers fell between 13% to 19%, year over year. As for net earnings and operating margins, these took a bigger hit during the first half of the year, with the exception of Solectron, which actually improved operating margins and, Flextronics which suffered only a minor decline following slight improvement in operating margins during the first quarter of 2007.

Looking ahead, most EMS providers issuing guidance for the third calendar quarter ‘07 expect a slight sequential improvement in revenues, whereas, Flextronics predicted an optimistic 10% to 20% growth rate. The EMS firms also provided a more optimistic outlook on earnings for the current quarter. Jabil expects operating margins to come in between 3% to 3.5% (up from 1.1% last quarter) and EPS to improve by 9% to as much as 30%. Flextronics expects earnings to improve by 10% to 20%; Sanmina expects to move from a loss of 4 cents per share to breaking even; and Celestica expects to turn profitable with (potentially) slightly improved operating performance this quarter.

Behind the numbers in the above table, EMS providers have struggled with a number of challenges. Celestica’s CEO, Craig Muhlhauser, summed up the primary issues he and his fellow CEOs in the EMS industry are obsessed with:

• Improve customer relationships
• Drive operational / financial performance
• Increase inventory turns and asset utilization
• Focus on efficiencies.

Cost control and performance issues dominated the agendas for these six firms’ quarterly reports.

Jabil is restructuring globally to improve performance and gain greater control over costs while Sanmina has experienced an ongoing wrestling match – especially with its components business (PCBA and enclosures) while trying to move most of its capacity to low cost regions. Flextronics, among others, has focused on reducing inventories while Solectron has been busy working on internal financial performance and efficiencies of its various manufacturing sites while it continues to struggle with its extensive services business. Both of these firms are also consumed with their looming integration, as Flextronics’ acquisition of Solectron has obtained regulatory approval and the companies expect to close the deal soon, perhaps before the end of October.

Plexus and Celestica reported spending significant time and resources fixing problems with or otherwise develop their operations in Mexico. For Plexus, effort has focused on investing in their Mexican operations with new leadership, infrastructure, IT tools, and inventory management systems as well as realigning cost structures and sales strategies. For Celestica, their Mexico problems are more drastic, following the collapse of their Mexican operations near the end of last year. Meanwhile, Celestica has taken steps to move projects to Asia (or disengage some projects altogether) while also developing a recovery strategy, which, while running behind goal-to-date, should show signs of improvement over the course of the next several quarters.

While internal, defensive, cost-control issues dominated the companies’ reports; most firms also gave weak end-user demand as the reason for poor performance, especially for the enterprise computing and communication segments. The one notable exception was Flextronics, which was fairly upbeat across a number of business segments, which was not surprising given its 30% growth during the first half of 2007. On the bright side, most mentioned new product wins and the expected positive comments regarding future opportunities. Most firms also discussed their vertical integration strategies to help boost performance and growth.

New growth challenges

A core challenge for most of these firms involves expansion into non-IT related business segments.

Celestica is looking to its consumer segments to spur growth as it faces challenges with some of its industrial sector accounts. For Flextronics, the automotive / medical / industrial segments have become a combined 11% of business that has grown significantly this year. Plexus saw sales jump beyond expectations with its medical segment and the Company is expecting a huge jump in aerospace / defense revenues later this year thanks to a project win announced the beginning of 2007. Sanmina is another firm doing well in the aerospace; defense, and automotive segments and is hoping to develop these segments further with future growth plans.

The buck stops here

Perhaps the most daunting of external factors is Wall Street.

Flextronics’ acquisition of Solectron attracted attention on each company’s investor conference call. Wall Street has been hounding EMS industry companies for the past several years to consolidate and rationalize the industry’s over-capacity.

Flextronics was upbeat about its prospects with acquiring Solectron, while Solectron avoided discussing the integration. As for the other companies, they each felt the merger will be good for the industry and otherwise expressed nice, non-committal comments.

But the other firms each had their own news on the corporate development front. Sanmina reported selling off several non-strategic assets and facilities; restructuring its component business, announcing a new management team, and working on efforts to shift capacity to low-cost regions. Sanmina also spent a good deal of time reviewing efforts to divest its PC and entry-level server business in a deal expected to close late October. (One party is believed to be ready to purchase approximately one-fourth of this business plus one-of-three affiliated facilities from Sanmina — while negotiations for the remainder are underway). Sanmina also devoted time to reviewing its strategy as it prepares to sell off one-third of its revenues with its PC operations.

Jabil showed progress with its integration of Green Point while also dealing with a probe into its options dating activity. The Company also is busy adding new capacity in China; India, Vietnam, and Romania. Plexus was also adding capacity in Asia in addition to working on its Mexican investment.

Groping through a typhoon

The EMS industry business challenges defined above – centering on operational excellence; demand from end-customers, reaching out to new OEM customers, and satisfying the pressure from Wall Street each combine to create the equivalent of a typhoon companies must navigate each quarter.

All of these problems, plus a host of others, contain multiple facets with second, third, and fourth-order consequences for EMS company performance.

The six EMS providers mentioned herein account for more than one-half of the total global EMS market; underpin our modern economy, are partnered with key global electronics OEMs in their respective industries, and maintain global manufacturing footprints, yet these multi-billion dollar businesses are dependent on flawless execution in order to live off 5% to 6% gross margins. One slip in inventory management; operations, or quality can erase any profits for the quarter.

This is our EMS industry.