EMS Takeaways From China -- Smith Barney Handset Tour
February 28, 2005 SUMMARY
* We recently completed the SB China handset tour which included meetings with numerous
handset component vendors, OEMs, and EMS
* Our key takeaways for EMS investors are: 1) broad-based demand for the EMS providers into Chinese New Year was a bit stronger than expected and follow-through post-Chinese New Year has remained relatively solid; 2) inventory adjustments at a number of large OEMs have substantially run their course and some customer are beginning to rebuild some buffer inventory as levels for select products may have gotten too lean; and 3) wireless telecom was an area cited by the EMS vendors as an area of relative strength quarter-to-date. Furthermore, expectations for 2H05 orders in the wireless infrastructure market remain firm as most companies that we visited during the tour expect that the Chinese government will issue 3G licenses by the end of this year.
OPINION
We recently completed Smith Barney's China Handset Tour, which included
meetings with fourteen companies throughout the country. Along with visits to
a number of handset component vendors and OEMs, we met with local management at
Solectron (SLR, 1H, $4.94) and Flextronics (FLEX, 1H, $13.75). Our meetings
tend to confirm our thesis that production levels for the EMS providers will
likely trough here in 1H05 and we could begin to see upside surprises over the
next few months as OEMs beginning pulling from their EMS partners at actual
demand levels and possibly even slightly above end demand for certain products
where inventory levels have become too lean.
For reference, our China Handset Tour included stops in Beijing, Shanghai, and
Shenzhen including meetings with:
* EMS providers Solectron and Flextronics,
* Passive component manufacturer Yageo Corporation,
* Handset OEMs DBTel, TCL, and ZTE,
* Handset case manufacturers Intops Electronics Company and Green Point
Technology,
* Handset keypad manufacturer Youeal Electronics,
* Handset battery manufacturer BYD Company, and
* Communications infrastructure companies China Telecom, China Unicom, Huawei,
and UT Starcom
Our main takeaways for EMS companies are below and we would refer investors to
separate notes from Smith Barney handset analyst Daryl Armstrong and
semiconductor analyst Craig Ellis for further implications and takeaways for
the broader end-market and component suppliers.
KEY TAKEAWAYS FROM OUR EMS MEETINGS
* Broad-based demand for the EMS providers into Chinese New Year was a bit
stronger than expected and follow-through post-Chinese New Year has
remained relatively solid.
* Inventory adjustments at a number of large OEMs have substantially run
their course and some customer are beginning to rebuild some buffer
inventory as levels for select products may have gotten too lean. This
is consistent with comments that we have heard from other EMS providers
that OEMs are concerned that as demand becomes more perishable, they
cannot afford to be caught short of "in-stock" products.
* Wireless telecom was an area cited by the EMS vendors as an area of
relative strength quarter-to-date. Furthermore, expectations for 2H05
orders in the wireless infrastructure market remain firm as most
companies that we visited during the tour expect that the Chinese
government will issue 3G licenses by the end of this year. While the
commentary about wireless infrastructure relative strength is positive,
we would note that the context of our discussions with the EMS providers
was with regional-level management and may not precisely reflect the
exact trends experienced at the corporate level. Having said that, we
believe that incremental strength in wireless infrastructure could also
benefit Sanmina (SANM, 1S, $5.63), which is leveraged to wireless
infrastructure both in its assembly business (~26% of revenue in
Communications Infrastructure -- wireline and wireless) and more
importantly in its high-margin components businesses (PCBs and
enclosures), which have struggled the past few quarters due to execution
issues. Sanmina management has been optimistic about 2H05 wireless
orders for several months and we believe that solid orders in this
segment in the second half of 2005 could be the much-needed antidote to
put Sanmina's components business on sounder footing.
The next important datapoints that EMS investors will receive are quarterly
earnings results from Jabil (JBL, 1H, $25.66) on March 17th and Solectron on
March 24th. We expect that results for both will reflect the relatively
positive commentary from our recent meetings and we would use any weakness
leading into their earnings reports as a buying opportunity.
AGGREGATE SUPPLY CHAIN INVENTORIES LEAN -- OEMS BEGINNING TO REBUILD INVENTORY
IN SELECT PRODUCTS
Our view has been that aggregate inventory levels throughout the supply chain
have been quite manageable over the last few quarters and in fact have hovered
near historic lows in terms of inventory to revenue (we would refer investors
to our quarterly inventory survey that we published on February 14th for a more
detailed analysis of aggregate supply chain inventories). Our recent meetings
tend to support our thesis that OEM inventory adjustments should be
substantially completed over the next few months, and indeed some OEMs are
already beginning to rebuild inventory in certain products. With EMS stocks
underperforming both the broader market indexes and the SOX year-to-date, we
believe that positive results over the next quarter could drive out-performance
in EMS stocks which appear to be discounting minimal margin leverage over the
next 12-months with the group trading at approximately 17x our CY05 estimates
and only 13x our CY06 estimates.
FIGURE 1. INVENTORY-TO-SALES RATIO OF SURVEYED SUPPLY CHAIN COMPANIES STILL
BELOW TREND
Source: Company reports and Smith Barney
FIGURE 2. HISTORICAL SUPPLY CHAIN INVENTORY -- % HELD AT EACH SEGMENT ALONG
THE SUPPLY CHAIN: 1Q91-4Q04
Source: Company reports and Smith Barney
FIGURE 3. HISTORICAL SUPPLY CHAIN INVENTORY DOLLARS BY SEGMENT: 1Q91-4Q04
Source: Company reports and Smith Barney
AS EMS PRODUCTION INFLECTION BECOMES MORE EVIDENT, EXPECT EMS STOCKS TO REFLECT
HEALTHY EARNINGS GROWTH EXPECTATIONS
We believe that as the inflection in EMS production becomes more evident, EMS
stock valuation will more fully reflect the estimated industry earnings growth
for '05 and '06, which we currently peg at approximately 50% and 38%,
respectively, on a market-weighted basis. Clearly the earnings growth that we
anticipate over the next 12-24 months is largely dependent on end-markets not
weakening further from here. Absent further deterioration in end-markets, we
expect that industry fundamentals will continue to show solid sequential
improvement. Average operating margins improved 115 basis points (y/y) in
2004, with industry-wide margins improving sequentially every quarter even
against a backdrop of slowing end-market demand and reduced production levels
due to OEM inventory adjustments.
REITERATE OUR THESIS
While investors will have to wait several more weeks for concrete evidence of
calendar 1Q end-demand, our recent company meetings tend to support our bullish
thesis on the EMS space and we would point to several key elements: 1) OEM
inventory adjustments are progressing on or even a bit ahead of plan; 2) the
supply chain is seeing a normal seasonal build for handsets which is
traditionally down 20%-30% quarter-over-quarter, and infrastructure appears to
be trending seasonally normal to slightly stronger than normal; 3) supply chain
players we recently met with are seeing an absence of order cancellations and
even some pockets of order upside according to the EMS providers; 4) component
pricing pressure appears to be abating as expectations for a normal seasonal
uptick in the second quarter come into focus.
Furthermore, as we indicated in our February 14th quarterly inventory analysis,
the sequential decline in days of inventory at the EMS providers and most of
the downstream players supports our thesis that EMS and OEM inventory will
continue to be worked down and bottom in 1H05. Indeed, the rise in component
suppliers' inventory levels as a percentage of overall supply chain inventories
speaks to the EMS industry's ability to push the inventory risk further back
into the supply-chain this cycle compared to prior cycles. This ability to
manage the supply chain is especially important as we continue to hear how OEMs
are asking/demanding that their supply-chain partners hold more inventory, as
not to be caught short in the case of normal fluctuations in end-market demand.
As such, we reiterate our thesis as follows:
* Expect EMS Fundamentals to Continue Improving Throughout 2005 -- EMS
fundamentals continue to show incremental improvement even though end-
market demand has decelerated and the group is in a weak part of the
electronics cycle. Double-digit top-line growth, driven by incremental
outsourcing, coupled with minimal expected capacity expansion in 2005,
augers well for earnings growth to continue to outpace top-line growth.
* EMS Production Should Trough by 1H05 -- We expect the EMS production
cycle will trough by the second quarter of 2005 and will likely trend
back to actual end-market demand levels. As demand and inventory
overhangs begin to lift following the March quarter, increasing EMS
production levels should serve as a greater-than-expected catalyst for
margin improvement. An uptick in demand from relatively higher margin
"core" EMS markets such as networking or telecom, which we are not
modeling, would add fuel to both the top-line and margins.
* Pending New Upcycle Argues for Handoff Back to More Potential Margin
Leverage...Buy Beta -- With Smith Barney's semiconductor team
anticipating the bottom of the semi-cycle by mid-2005, combined with
our expectations for EMS production also troughing by mid-2005, we
advocate investors positioning in stocks possessing relatively greater
margin leverage. Furthermore, our EMS group's relatively high average
beta (1.8) makes the group a good vehicle for playing the turn in the
electronics cycle.
VALUATION AND RISKS
Solectron (SLR -- $4.94; 1H)
Valuation
Our 12-month target price of $7 is approximately 20x our calendar 2006 EPS
estimate of $0.35. We believe the 20x multiple is reasonable as the company
continues to de-lever its balance sheet and restructure its manufacturing
operations. Over the past 10-years our coverage universe has traded at a median
forward 12-month P/E multiple of 23x and Solectron has traded at a median P/E
median multiple of 24x forward 1-year estimates. Our target multiple is below
Solectron's long-term median multiple due to our belief that the historic
median multiple is skewed from the hyper-growth of the pre-bubble period.
Our $7 target price is also based on a multiple of 0.5x our calendar 2006
revenue estimate of $13.7 billion. During the past ten years, Solectron has
traded in a range of 0.1x--2.7x sales, with a median of 0.9x. We believe a
discount to its historical median is justified due to slightly lower growth
rates in the future compared to the past decade as well as slightly lower
industry-average margins, which are still recovering from cyclically depressed
levels.
Risks
Our High Risk rating on Solectron is due to the tendency of EMS stocks to have
relatively high betas, in our view because of the cyclical nature of the
electronics industry and the relatively immature business model of the EMS
industry. New business wins tend to be lumpy, which makes it difficult to
predict when incremental revenues will flow into the P&L. Thus, earnings
stability tends to be lower than the market average.
General risks to companies in the EMS sector and, hence, potential risks to
investment in Solectron shares include 1) a downturn in the electronics
industry, resulting in lower demand for Solectron's customers' products; 2) a
slackening in the pace of outsourcing by OEMs; 3) management and integration of
acquisitions and/or expansions; 4) risks of international operations; and 5)
challenges associated with the fast ramp of new programs, including components
shortages. In addition, Solectron continues to integrate its IT systems from
its various acquisitions and calls into question its ability to fully leverage
its global manufacturing and procurement capabilities.
If the impact on the company from any of these factors proves to be greater
than we anticipate, the stock will likely have difficulty achieving our target
price.
Jabil Circuit (JBL-- $25.68; 1H)
Valuation
Our $33 target price represents 22x our calendar 2006 EPS of $1.52. Jabil's
business momentum during the past year has been better than industry average,
and the company appears poised to deliver record revenue and earnings in fiscal
2005. We believe Jabil also has the "law of small numbers" working in its
favor. As a recovery in demand is evident, we believe the market will discount
Jabil's ability to grow more quickly than its larger peers for a longer period
due to its smaller base.
Furthermore, during the boom years of the 1990s, Jabil primarily grew its
business through organic new business wins and did not undertake significant
acquisitions. As a result, Jabil has taken the fewest restructuring charges of
the tier-1 EMS providers during the downturn and has been able to maintain
industry-leading operating margins. We estimate that Jabil's earnings power is
north of $1.50 and believe that a premium valuation to the group is warranted
due to its superior execution and strong business momentum. On an earnings
power basis, Jabil trades at a premium of approximately 20% compared to our
estimates of the average normalized P/E for group. We believe that the
significant gap in Jabil's operating performance and margins warrant the
premium valuation and we believe that the valuation premium could widen if that
gap persists and investors gravitate toward higher-quality stocks.
Over the past ten years, our coverage universe has traded at a median forward
12-month (F12) P/E multiple of 23x, and Jabil stock has traded at a median P/E
multiple of 23x forward one-year estimates. Our target multiple approximates
the industry long-term median multiple and is above the average target multiple
for our coverage EMS universe due to our expectation for above industry-average
revenue growth in calendar 2006 and Jabil's industry leading margins.
Our $33 target price is also based on a price-to-sales multiple of 0.8x our
calendar 2006 revenue estimate of $8.3 billion. During the past ten years, we
note that Jabil has traded in the range of 0.2x--3.7x sales, with a median of
1.1x. We believe the modest discount to the historical median is justified due
to slightly lower sales growth rates in the future compared to the past decade.
Risks
Our High Risk rating on Jabil is due to the tendency of EMS stocks to have
relatively high betas, in our view because of the cyclical nature of the
electronics industry and the relatively immature business model of the EMS
industry. New business wins tend to be lumpy, which makes it difficult to
predict when incremental revenues will flow into the P&L. Thus, earnings
stability tends to be lower than the market average.
General risks to companies in the EMS sector and, hence, potential risks to
investment in Jabil shares include 1) a downturn in the electronics industry,
resulting in lower demand for Jabil's customers' products; 2) a slackening in
the pace of outsourcing by OEMs; 3) management and integration of acquisitions
and/or expansions; 4) risks of international operations; and 5) challenges
associated with the fast ramp of new programs, including components shortages.
Jabil also faces company-specific risks. Sales from its top ten customers are
approximately 65% of the total, which is at the higher end of the range of its
tier-1 EMS peers. However, the company continues to add new customers to its
base book of business to reduce its concentration risk. Jabil has also
announced five acquisitions since the beginning of 2002. Although acquisitions
are common to the EMS industry, Jabil was not historically very acquisitive
prior to 2002. Therefore, the recent acquisitions inject a bit more
integration risk into the story.
If the impact of any of these factors proves greater than anticipated, the
stock could have difficulty achieving our price target.
Sanmina (SANM--$5.64; 1S)
Valuation
Our target price of $9.50 is approximately 18x our calendar 2006 EPS estimate
of $0.53. We believe an 18x target multiple remains reasonable as the company
is still undergoing restructurings that have to yet to be felt in the company's
profitability. Over the past 10 years our coverage universe has traded at a
median forward 12-month P/E multiple of 23x and Sanmina has traded at a median
P/E median multiple of 26x forward 1-year estimates. While Sanmina has a high
degree of operating leverage relative to the bulk of our coverage universe,
because of its higher fixed-cost components businesses, the company is still
several quarters away from actually realizing the full operating leverage in
its model. We believe that a multiple below Sanmina's historic median is
warranted as: 1) industry growth rates over the next several years will be well
below the 45% CAGR that the industry experienced during the '90s, and 2)
Sanmina's profitability profile and operating leverage since its acquisition of
SCI-Systems (in December 2001) is meaningfully lower compared to its pre-
acquisition profile.
Our $9.50 target price is also based on a price-to-sales multiple of 0.3x our
calendar 2006 revenue estimate of $14.6 billion. During the past ten years
Sanmina has traded in the range of 0.1x-4.9x sales with a median of 1.3x. We
are applying a multiple at the low-end of its historical price-to-sales range
as a high percentage of its sales are related to the very low margin PC
integration business, which it acquired from SCI Systems (12/01).
Risks
We rate Sanmina-SCI Speculative Risk because EMS stocks tend to have relatively
high betas due in part to the cyclical nature of the electronics industry as
well as the relatively immature business model of the EMS industry. New
business wins tend to be lumpy which makes it difficult to predict when
incremental revenue will flow into the P&L. As such, earnings stability tends
to be lower than the market average.
Generally speaking, risks to companies in the EMS sector, and hence, potential
risks to investment in Sanmina-SCI shares, include: 1) A downturn in the
electronics industry, resulting in lower demand for Sanmina-SCI's customers'
products; 2) a slackening in the pace of outsourcing by OEMs; 3) management and
integration of acquisitions and/or expansions; 4) risks of international
operations; and 5) challenges associated with the fast ramp of new programs,
including components shortages.
Risks specific to Sanmina-SCI include its high-fixed-cost printed circuit board
(PCB) and enclosure businesses. Both of these businesses have become
profitable, up from below break-even for several quarters prior to 1Q02.
Sanmina-SCI is a leveraged play on a recovery in "big box" communications
equipment sales, which is Sanmina-SCI's sweet spot, in our view. Sanmina-SCI's
debt load, though manageable, is also among the highest in the industry.
If the impact on the company from any of these factors proves to be greater
than we anticipate, the stock will likely have difficulty achieving our target
price.
ANALYST CERTIFICATION APPENDIX A-1
I, David Pescherine, the author of this report, hereby certify that all of the
views expressed in this rese |
