Private equity and EMS risk
David Rubenstein, co-founder of Carlyle Group, was sourced in a recent Wall Street Journal article saying he expects the flow of private equity deals to pick up in the coming months.
Private equity firms look for money from high net worth individuals and wealthy investor groups and use the funds to take over; change, and resell companies.
Private equity firms usually invest in growth businesses or organizations that serve a specific niche in a particular industry. EMS isn’t typically categorized as a growth industry.
Meanwhile, more EMS providers are finding it difficult to strengthen their position in the marketplace. Many have not been able to find sure footing for some time. In some cases, it would seem some EMS companies have no idea about channel branding strategic marketing (online and in print) or understanding differentiation and company and industry value propositions.
Even Top 10 EMS providers such as Jabil Circuit, Celestica and Sanmina-SCI can experience trouble for extended periods of time. (The latter more recently trading at just a fraction of balance sheet asset value). Electronics contract manufacturing services can be a tough haul, indeed. Margins are thin and pressure from savvy OEMs wanting continuous cost savings can be relentless.
Today, there are private equity beacons searching for suitable EMS companies to add to their portfolios. But, not all EMS providers are alike. Below are some questions and points of interest investment firms should consider when deciding whether or not an EMS company might be a good risk.
- Is an experienced executive team in place? If a board of directors exists, does it have adequate depth and scope of experience in the right places? Is the chairman of the board also the CEO? If so, what are the chances board members are telling the chairman (CEO) what he ‘wants’ to hear vs. what should be said?
- Does management have a good network of industry relationships and contacts?
- Is management skilled at understanding industry pricing drivers and negotiating service level agreements (which will be different for various industries such as medical) all of which create profitable transfer pricing?
- What percentage of the EMS business is front-end design? What percentage is SMT and printed circuit board assembly? Does the EMS provider offer back-end services? What percentage is assembly integration or box build and other high value-add?
- How efficient / effective is program management? Program management is often spread too thin. Are teams actively managing accounts such as collecting on engineering change orders (ECO)? Are customers invoiced accordingly when forcing shipments outside of pre-determined delivery schedules?
- Which end-markets does the EMS company serve? Some end-markets, such as medical electronics outsourcing or defense yield higher margin opportunities but also require higher standards for compliance / certification.
- What are the barriers-to-entry for serving more profitable end-markets?
- How are customer end-markets performing relative to the EMS industry? Are these markets expanding or contracting?
- What destinations does the EMS company have facilities in? What is the amount, or percentage of business deriving revenue from low-cost geographies? Does a geographic revenue concentration exist that might put overall revenue at risk?
- Is the EMS provider concentrating too much in one market segment? If so, is the EMS company a leading provider of services in that market?
- What percentage of business comes from top customers? What markets do these top customers serve? Does a customer concentration exist that might put overall revenue at risk?
- What are the EMS provider’s true gross margins? What are equivalent net margins? How is operating margin measured? Are gross numbers accurate or are one or two customers giving the EMS company business at an exceptionally good rate-of-margin, yet unsustainable, to make an equity deal (read: rescue) more attractive to investors?
- How successful is the EMS provider at managing materials / inventory? EMS is a material-intensive game. Who holds most of the EMS provider’s inventory? When is inventory typically transferred to the OEM’s books?
- How are inventory turns measured? Take, for instance, an EMS provider with annual revenues of $320 million ($80M per quarter). With $320M revenues at, say (ahem), 12% gross margin (some guys really can claim this), this equals roughly $38M gross profit and $282M COGS (cost of goods sold), where: $282M COGS equals $23.5M in inventory per month.
$23.5M inventory with, say, a $16M inventory balance on the books means the EMS provider has less than one month’s inventory on hand. Turns = 12.
This EMS provider either has a very efficient supply chain with great vendor partner relations and / or he has customers with easily forecasted markets.
- What is the return on equity (ROE)? Downside risk is often worth taking. Just because an EMS company’s ROE may be dropping, don’t pass it up. Find out why. Is the firm actively working to reduce its debt? This will impact ROE.
- Does the EMS provider carry a lot of debt? Is the debt to equity ratio reasonable for industry? Would the company’s standing in industry warrant going to the debt markets to raise additional cash, if needed?