Investors considering the electronics-manufacturing services sector haven't had much to inspire them over the past quarters -- even years -- and that trend hasn't changed much in the latest quarter.Instead of consistent growth, EMS companies have offered investors consistent restructuring and a glut of inventory, rather than surplus profits. "The last two to three years have been a bit of a reality check for these guys, which tends to be more painful than not," says Amit Daryanani, an analyst with RBC Capital Markets. The industry, which has traditionally assembled printed circuit boards for its original equipment manufacturer clients like PC companies and consumer-electronics firms, has tried to capitalize on the outsourcing trend, expanding their services into areas like design and repair services and branching out into new markets to grow. But at the same time, a number of the companies are still rebuilding from the tech bust while scrambling to hold on to market share. "Generally speaking, I would say that the EMS companies in the U.S are losing share to the Asian companies, specifically, Hon Hai," says Ben Lu, an analyst who follows the industry for J. & W. Seligman. His firm holds shares of Hon Hai, which is traded on the Taiwan Stock Exchange, and Jabil Circuit ( JBL - Get Report). As the largest EMS provider in the world, Hon Hai's sales are expected to grow over 35% to more than $35 billion this year, Lu says. Its nearest competitor is about half its size: Singapore-based Flextronics ( FLEX - Get Report)
Jabil, the sector's consistent stalwart, posted a
rare earnings miss in June and announced plans to cut jobs and close plants. It is also undergoing an options probe. Plexus ( PLXS - Get Report), which soared earlier in the year, disappointed investors in July with weak guidance. "There's excess capacity in the industry," Daryanani says. "What I wonder is, given the excessive competition, if OEMs have a stronger leverage position, EMS companies are holding the extra inventory to keep the current business in place." (His firm seeks to do business with the companies it covers.) After the second quarter, excess inventory at EMS firms was up about 16.5%, on average, while companies guided revenue to grow about 7% or 8% sequentially, Daryanani says. Inventory and revenue should build at about the same pace. "If demand doesn't live up to expectations for the second half of the year, you're more likely than not to have an inventory correction in the supply chain," Daryanani says. Part of the reason for the inventory build-up is also due to restructuring, as companies move from high-cost to low-cost regions, he says. While closing plants should -- in theory -- pay off in the long run, it also hurts margins because firms are stuck with fixed assets and depreciation, Seligman's Lu says.
And companies, like Celestica ( CLS - Get Report), Solectron ( SLR) and Sanmina-SCI ( SANM - Get Report), which have a larger presence in the high-end communications business (like routers and switches) have had a harder time recovering from the tech downturn and seem to be perpetually restructuring. When Solectron
reported its third-quarter results at the end of June, it said it planned further restructuring to boost profitability. Investors in these companies have endured a lot of pain. As for Sanmina and Solectron, "their performance has been atrocious over the past few years," says Richard Stice, an equity analyst with Standard & Poor's. As of Tuesday's close, Sanmina has tumbled 23.7%, Solectron is off 14.1% and Celestica has dropped 11% since the start of the year. Jabil has fallen 25.2%, while Plexus, which was on a spring tear -- topping $46 in May -- now trades at $24.36.Meanwhile, Benchmark Electronics ( BHE - Get Report) is up 10.6%, and Flextronics has grown 13.6% since the beginning of 2006. Cisco's ( CSCO - Get Report) good performance in the latest quarter, which helped lift the Nasdaq, should help provide stable revenue for Celestica and Solectron, which count the networking giant among their largest customers. Still, analysts say the constant restructuring activity is a more pressing issue. Adding to its woes, Sanmina is under investigation by the Securities and Exchange Commission and recently received a delisting warning from Nasdaq because it failed to meet a deadline to file its most recent 10-Q.
To propel growth, EMS firms have been expanding into other areas, like the medical, automotive and industrial sectors. These nontraditional markets have helped, but they are growing off a smaller base, Stice says. Projects in the newer areas are generally smaller and take longer, says Seligman's Lu. For instance, the market for devices like heart monitors can't compare with the millions of laptops and cell phones sold each year, and regulatory approvals are much stricter in that area. Still, even with smaller volume, the projects are more complex and the margins are higher. For his firm to dive into other U.S-based EMS companies, they would need to show consistent revenue growth between 20% to 30%, at a profitable pace and with better margins, Lu says. For example, Celestica sales were essentially flat this quarter compared with last year, and Solectron sales grew 3.8%. Investors are likely to follow suit and stay on the sidelines.