Wall Street on 6 EMS companies in a weakening economy

Investment bank Deutsche Bank expects EMS industry revenue to decline in 2009 and is revising its estimates and price targets down for EMS company stocks, and now expects combined EMS revenues to decline 7% in 2009. Since EMS companies reported 3Q results, the economy and the outlook for tech spending have significantly deteriorated. Yet despite the myriad of negative news, Consensus EMS estimates remain relatively unchanged since October. Deutsche Bank’s revised estimates are now 4% and 17% below Consensus revenue and earnings per share, respectively. While the bank feels EMS shares prices appear fairly valued on the bank’s revised estimates, Deutsche Bank believes there is still near-term downside risk as expectations are reset. It's weak and getting weaker With few exceptions, technology companies have become more cautious in recent weeks, with many reducing prior guidance due to further weakening in end demand. Visibility remains extremely limited with many companies declining to offer guidance for 2009. Perhaps unsurprisingly, industry forecasters and economists are now expecting a pretty bleak year in 2009. Leading research firm IDC recently revised down its expectations for IT hardware spending to a negative 4% in 2009, with flat spending predicted in 2010. Earlier in December, Deutsche Bank’s economists updated their global GDP growth assumptions for 2009, now expecting growth of just 0.2%, with a 2% decline predicted in the US. In the current environment, Deutsche Bank finds it unlikely the EMS industry will see revenue growth in 2009. Coupled with negative news from companies, economic data has continued to deteriorate, with consumer confidence at lows not seen in more than 20 years and unemployment at levels not seen since 1993. In general, tech hardware spending grows at about 1.5x to 2x GDP, with EMS revenue being highly correlated to overall tech spending (99% correlation to US IT spending and 96% correlation to world GDP). Because EMS revenue is more volatile than overall tech spending, Deutsche Bank would expect EMS industry revenues to decline more than global IT spending in 2009. Deutsche Bank’s revised estimates are for a combined 7% revenue decline in 2009 for the 6 US EMS companies the bank covers which are Flextronics, Jabil Circuit, Celestica, Sanmina-SCI, Benchmark Electronics and Plexus. This assumes EMS revenue declines ~13% year-on-year in C4Q08, with negative year-on-year growth in the low double-digits in the first 3 quarters of 2009. Deutsche Bank expects year-on-year growth to resume in C4Q09, with mid-single digit revenue growth in 2010. Negative IT hardware growth suggests negative EMS growth EMS revenue is highly correlated to IT spending and GDP, with higher volatility. With leading research firm IDC expecting IT hardware revenue to decline 4% in 2009, Deutsche Bank expects revenue for its EMS group of companies that it follows to decline by a combined 7% in 2009. By segment, Deutsche Bank expects core-EMS segments to see the largest declines, with consumer segments down 9% and emerging segments down more modestly. The bank sees the largest declines in traditional EMS sectors like servers, networking and telecom, while it expects more modest declines in emerging segments like medical electronics and industrial. For the consumer segments (flat panel TVs, mobile phones, printers, etc.), Deutsche Bank expects declines to be somewhere between traditional EMS and emerging segments, and is modeling combined EMS revenue to be down ~9% in 2009. EMS estimates have not been reset, creating downside risk to expectations Despite the myriad of negative news, EMS company estimates have not appreciably changed since the end of October. In addition, for a few of the EMS companies under Deutsche Bank’s coverage (Jabil and Plexus), Consensus estimates still expect revenue and earnings per share growth in FY09, despite most economic estimates which predict a very difficult year for corporate and consumer spending in 2009. Deutsche Bank believes Wall Street expectations need to be reset to more reasonable levels, which creates near-term downside risk to EMS share prices. On average, Deutsche Bank’s revised estimates are now 4% below Consensus revenue and 17% below Consensus EPS. EMS shares trading at tangible book suggests further good will write-downs likely With most of the EMS shares in Deutsche Bank’s coverage group trading at or below tangible book, Deutsche Bank believes there is potential for further write downs of goodwill and intangibles. EMS company Sanmina-SCI has already written down all of its goodwill and intangibles, and Flextronics has indicated that a goodwill write-down is imminent. In the past few months, many investor calls Deutsch Bank has had have focused on the current debt levels of the EMS companies the bank follows, their liquidity, and bank covenants. In general, the bank feels the EMS companies it follows are well-funded with only Flextronics and Jabil having debt coming due in 2009. All companies the bank is following are currently trading near or below tangible book value, which suggests that write downs of goodwill and intangibles may be necessary. Sanmina-SCI has already written off all of its goodwill and intangibles, and Flextronics has indicated that it will need to take a substantial write-down (if not all). As such, Deutsche Bank is now looking at leverage in terms of tangible capital. Based on debt-to-total tangible capital, the bank feels its important to note Sanmina-SCI, Flextronics, and Jabil each appear the most highly levered. EMS group looks fairly valued at 10x new Deutsche Bank estimates Deutsche Bank expects EMS shares to trade at 10x the bank’s revised estimates, which is at the low end of historical forward P/E multiple ranges of 3-20x. For smaller EMS players, like Benchmark Electronics and Plexus, Deutsche Bank expects a bit higher multiple (12x) due to better potential for growth, lower leverage, and higher ROIC. Deutsche Bank believes the group is fairly valued at current levels, with downside risk from further estimate revisions balanced by upside risk from improvements in the demand outlook. Looking into more detail at share prices, Deutsche Bank feels Flextronics is currently trading at a discount to the rest of the group. Risks per EMS company Share prices of EMS stocks have historically been volatile, due to the highly transactional nature of the EMS business which leads to significant swings in profitability. In addition, the EMS industry is also dependent on OEM sales, which is driven by the health of the overall macroeconomic environment. Flextronics Specific risks to Deutsche Bank’s investment rating on Flextronics includes the loss of a significant customer like Sony-Ericsson, the failure or bankruptcy of a top 10 customer, further increases in distressed customers, a reduction in liquidity from current levels, and a breach of debt covenants due to lower-than-expected cash flows. Jabil Circuit Specific positive risks to Deutsche Bank’s investment rating on Jabil includes faster-than-expected return to 4% operating margins, and significant deal wins to offset the loss of Nokia and Philips business. Negative risks to the bank’s investment rating include a greater-than-expected decline in mobile business; increased losses in displays, deterioration in balance sheet metrics which would impact cash generation, and the loss of one of its top customers (Cisco, Philips, and HP). Celestica Specific positive risks to Deutsche Bank’s investment rating on Celestica include a return to revenue growth which would drive operating margin leverage; further improvements in balance sheet metrics to improve cash, and increased business due to competitive deal wins. Negative risks include, a deterioration in balance sheet metrics and the loss of a top 10 customer (Sun, IBM and Cisco). Sanmina-SCI Specific positive risks to Deutsche Bank’s investment rating on Sanmina-SCI include increased profitability in the components and enclosure businesses; better-than-expected management of balance sheet metrics to improve cash, and increased business due to competitive deal wins. Negative risks to the bank’s investment rating on Sanmina-SCI include new losses in the components and enclosure businesses;  deterioration in balance sheet metrics, the loss of one of its top customers (IBM, HP), a reduction in liquidity from current levels, and a breach of debt covenants due to lower-than-expected cash flows. Benchmark Electronics Specific positive risks to Deutsche Bank’s investment rating on Benchmark include increased business due to competitive deal wins, better business trends at Sun Microsystems, and improvements in the medical electronics segment. Negative risks include the loss of a top customer (Sun Microsystems or EMC), higher-than-expected revenue declines in the medical segment and the ramp of new facilities in China. Plexus Deutsche Bank’s current price target for Plexus implies the EMS company trades at 12x our FY09 earnings per share of $1.45. Deutsche Bank expects Plexus’s multiple to be a bit higher than the rest of the EMS group due to its higher growth potential, higher margin profile and higher ROIC. Source: Deutsche Bank, VentureOutsource.com, December 2008 Article sponsored by TechScapeReport.com