EMS: Victims of Wait-and-See Spending
An unknown looming over some technology stocks is how long it will be before businesses spend more on computers, software, storage, networking, and other gear. Storage maker Network Appliance (NTAP) recently reminded investors that some areas of spending are still on the weak side (see BusinessWeek.com, 5/24/07, "Hard Knocks for NetApp").
One early predictor of spending can be found by examining order trends at electronic manufacturing services (EMS) companies, which make many of the products that tech companies sell. "Their orders will slow down first," says Jawahar Hingorani, who follows EMS companies for Standard & Poor's Equity Research.
Spending on enterprise computing and storage is notably weak, consumer electronics is a bit slower, and telecom is a "mixed bag," Hingorani says. Meanwhile, spending on automotive components and industrial machinery is going up in the U.S., he says.
Take one look at this industry and you'll see the inactivity reflected in the stocks. The S&P Electronic Manufacturing Services index has dropped 1% this year through May 25, vs. a 6.9% rise for the S&P 500 index. In 2006, the industry fell 5.1%, vs. a 13.6% gain in the S&P 500.
Hingorani says the EMS group generates low operating profit margins—typically no higher than 4% to 5%—and is easily divided by the "have and have-nots." The laggards are characterized by operational difficulty and inventory problems—"They just can't get out of their own way," he explains. The successful ones have moved into low-cost manufacturing areas of Asia and have diversified into many areas such as medical technology, automotive components, and industrial machinery, and have a long history of good execution, he says.
BusinessWeek's Karyn McCormack spoke with Hingorani on May 25 about when he sees a recovery in tech spending and his opinions on EMS stocks. Edited excerpts from their conversation follow.
Note: Jawahar Hingorani is an S&P Equity Research analyst. He has no ownership interest in, or affiliation with, any of the companies on which he writes research. All of the views expressed here accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed.
There are still concerns about corporate spending on technology, as seen in NetApp's disappointing outlook on May 24. What's the trend in the EMS sector?
In March, tech companies that were customers of EMS companies said they were seeing a softer period, but their sales were not affected. But EMS companies had already started to see a slowdown. Plus everyone was expecting the economy would slow.
Now, as we've come through April and May, the customers of EMS have said that corporations are still taking a wait-and-see approach to spending on computers, storage, networking, and associated software. One side of the EMS segment is the telecom companies. We found that because of all the consolidation in the industry, there's also a wait-and-see approach to see which vendors will win.
When do you see a recovery in spending?
I think the December quarter is the earliest we'll see a resumption in enterprise spending because of the economy, and housing prices are down a lot. The interest rate picture is iffy, so we could see housing affecting consumer spending. [For] anyone that caters to consumers, [that] could lead to lesser spending and also more competition because companies are chasing fewer dollars.
What are the other challenges faced by the EMS industry?
Managing inventories and operations, and dealing with ordering patterns. EMS companies have to buy materials and build products, and then sometimes get caught between holding raw materials and end up holding finished inventory if an order gets delayed. Companies that do a good job of managing that, and negotiating better deals with customers, stand to do better than those who don't. EMS's operating margins are slim—they don't get higher than 4% to 5%.
What are some EMS companies doing right?
Companies that have expanded in low-cost geographies, like Asia and Eastern Europe, have had, in turn, a lower cost structure, so they're a little more competitive and better positioned to handle challenges in the economic environment. That, combined with a diversification within their end-market segments—serving computing, storage, industrial, medical, and automotive industries—helps mitigate a slowdown in the North American economy.
What determines who does the best is execution. The leaders in the group are Flextronics (FLEX) and Jabil Circuit (JBL). Some players might have decent sales growth, but operating expenses continue to be high as a percentage of revenues. They need to manage their inventories. Some companies have perennial ongoing restructuring costs.
Which stocks in this group do you like?
I downgraded Jabil Circuit on May 24 to hold from buy because its consumer business is 30% of revenue and that seems a little iffy now, not just because of our forecast for a slower economy. It is realigning its consumer business and it could take a while for margins to get back up to speed. What's unfortunate there is it's happening at a time when business is slowing down. But when business picks up, they'll be ready because they have a history of good execution.
Jabil was a net user of cash in first quarter 2007 and was cash neutral (cash from operations) in the second quarter because of an acquisition—and operating expenses rose. That's a little concerning. I figure Jabil will generate $12 billion in revenue this year.
Flextronics is the other leader I cover—I have a buy opinion on the stock. It will have almost $19 billion in estimated revenue for 2007. It has a similar profile to Jabil, but Flextronics does more business on the cell-phone side. Benchmark Electronics (BHE) is also ranked buy. In my opinion, Benchmark does a good job of execution and does have a presence in diversified markets like medical.
And which ones should investors avoid?
Right now, I have a strong sell on Plexus (PLXS). Most people would take one look at it and say the stock is disagreeing with you. I don't know why the stock has performed so well. That's why it is a 1 STARS stock. Based on fundamentals alone, I don't see a turnaround coming soon. For fiscal year 2007, I see a 2% rise in sales and maybe an 8% rise in 2008—and it only has $180 million in cash. So I'm confounded as to why the stock is on a tear.
Sanmina-SCI (SANM) and Solectron (SLR) are both ranked hold. They have $10 billion-plus in revenue, and both are trading in the $3 range. Both have low operating margins and sit on sizable cash amounts. Sanmina had a stock options probe that extended for a while. Solectron has shown growth in revenue year over year, but it continues to struggle from an operating profit standpoint. Solectron is at $3, trading at the lower end of price-to-sales and is sitting on about $1 billion in cash.
I also have a hold recommendation on Celestica (CLS). It has had ongoing problems in Mexico and Europe with its production and inventory management, so it has been restructuring for a while. Its Asia operations are doing well, and the company is trying to follow the lead of the recovery in its Asia operations for the rest of its manufacturing facilities.
Do you think EMS companies might be attractive to private equity investors?
A lot of these companies have been increasing revenues and they sit on a lot of cash, but operating margins are low. We've seen private equity investors acquire companies with sound fundamentals, but operations are inefficient or poorly managed. They take the cash on the company's balance sheet and lever the balance sheet with debt. When they take a company private, they can make bolder moves—such as layoffs or other kinds of restructuring—because they're not under the scrutiny of the market. The goal is to make the parts greater than the whole that they bought. In two to five years, they sell the company in parts or whole and make a handsome profit. I wonder if EMS companies fall into that mold. It's a very tough space to be in.