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OEM audit of contract electronic services and EMS financial due diligence

By Mark Zetter


From OEM C-level to program manager, OEMs can be more savvy during financial due diligence of potential contract EMS manufacturing partners. OEMs must learn to look at any given situation from more than one angle. When OEMs evaluate electronics contract manufacturers, it’s not enough that a particular contract manufacturer has a history or experience in the field of expertise, or product end-markets, the OEM is marketing its products in.

OEM executives must also be comfortable understanding the contract manufacturer’s financial position relative to his business profit objectives and, that the contract manufacturer will be around for a while to serve the needs of the OEM.

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Below are some of the financial operating and overall company indicators, and a few possibly related causes, OEM executives might want to look into more closely when evaluating contract manufacturers for the purpose of engagement. (Read: How to compare Flex, Jabil, Sanmina, Celestica manufacturing supply chain capabilities)

Naturally, it is easier to gain access to some of this information from publicly traded contract manufacturing companies. (Click here for more detail on metrics and liability)

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Earnings statements

Inventories
High EMS inventories could indicate quality of products manufactured by the EMS manufacturer has slipped; EMS competition is building a better-quality product for the same customer, or some of the contract manufacturers’ customers are financially strapped and EMS production costs are out of line at the contract manufacturer and they are no longer price competitive.

One question executives should ask is, “are sales falling or is production rising too fast?” Keep in mind, companies may hold back some inventories while waiting for new product introductions (NPI).

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Rising receivables

Most explanations for rising receivables are usually bad if receivables are rising faster than sales (relative percentage for each). Possibilities for this might include: customers are paying the contract manufacturer to slowly (again, due to financial troubles of their own, or business disputes) ‘channel stuffing’ or, increased shipments at quarter end to help make the quarter numbers (essentially, stealing from the following quarter) could be talking place.

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Extraordinary losses
Look for inconsistencies. Let’s say that years one through three for the OEM, his EMS manufacturer reports steadily increasing operating earning profits (with his stock price rising). Then year four comes and the provider reports an extraordinary loss per share, but adds that operating earnings (before the loss) were healthy. This could mean the there was neglect by the EMS firm in capital spending necessary to maintain infrastructure in a high CapEx industry.

Asset sales
EMS companies sometimes sell a profitable business segment or division to raise earnings. OEMs should place a smaller value on earnings derived from asset sales vs. core operations.

Research
With evolving and emerging technologies such as robotics, VR, additive manufacturing, nano technologies..contract manufacturers need to keep up. There should always be a good reason if R&D budgets are cut. Usually, there is not and the company is just trying to inflate earnings, if only temporarily, so be direct when asking questions.

Reduced capital spending

Again. Look for reductions. Capital spending is usually necessary to remain competitive in EMS. But this can be deceiving when reviewed during periods of low utilization rates across the industry.


Earnings growth

For contract manufacturing companies with operations in foreign countries, check to see the growth is ‘true’ and not due to a majority of earnings reported under the rate in one particular country – using that country’s currency exchange rate. Currency translation effects can end up in the income statement or the equity section of the balance sheet, decided by internal accounting rules. Effects that end up in the income statement are not part of continuing operations.

Out of balance growth
This can be difficult to determine. Revenue and earnings should rise roughly in tandem. When revenue rises faster than earnings, this could be a sign profit margins are slipping. Maybe the EMS manufacturer is not managing his business properly. It happens. Determine whether you feel your EMS partner CEO pays attention to details and can drive attention-to-details internally to hold EMS functional teams accountable. And if EMS earnings rise faster than revenue, earnings growth is most likely not sustainable. Growth in revenue should be larger than growth in accounts receivable.

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Key operating indicators

Like any industry, the contract electronics solutions industry has its own set of peculiarities. EMS manufacturers can typically carry more than their share of debt compared to companies in other industries. For example, average debt as a percentage of equity is roughly 18%, while many EMS providers operate from a revolving line of credit they draw from regularly.

Contrary to what EMS providers say, and their role as the operations experts, EMS executives are not very sophisticated managers when it comes to financing and hide behind losses in productivity execution in their S,G&A with loosely managed indirect labor workflows. Meanwhile, there are EMS industry standards for most of the financial metrics in contract EMS. A few of the more common industry metrics include:

  • Days of Inventory
    Inventory (two period average) / Cost of Goods Sold / Number of Days
    Inventory days measures the number of days inventory your EMS providers has given current production levels. The lower the number of days, the more efficient EMS management is at managing inventory, given the diverse product mix and OEM customer diversification preferences the EMS providers go after.
  • Days Sales Outstanding (DSO)
    Receivables (two period average) / Revenues / Number of Days
    Again. lower the number the better the contract manufacturer is at managing finances and his customers.
  • Days of Payable
    Payables (two period average) / COGS + SG&A / Number of Days
    Typically, the higher the number the better position the contract manufacturer is in with his suppliers and vendors. However, a high number could also translate to the contract manufacturer not being able to pay his bills – for a number of reasons.
  • Cash Conversion Cycle
    Days of Inventory + DSO – Days of Payable
    The amount of time it takes from the contract manufacturer placing orders with vendors; pipelining the materials in-house, producing the materials into finished goods inventory (FGI), shipping to his customers and collecting payment for services (accounts receivable). Shorter the period the better for EMS manufacturers.

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As tariffs and supply chain compliance play greater roles influencing companies, some OEMs interested in obtaining knowledge for enhancing their ASEAN supply chain strategy with non-China contract electronics can request a list of non-China EMS provider locations and capabilities here.




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