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EMS v ODM: Pegatron after the turnaround

Pegatron goal to run EMS and ODM business models leading to internal conflict due to limited R&D resources

Given ODM Wistron’s ‘lite’ EMS offering, it causes pause making us wonder if ODM companies can really feel confident they can create and realize true profit-making EMS ventures given the higher margins their typical ODM work mandates (v. often lower EMS margins) and the lackluster performance of even large, vertically-integrated EMS providers recently like Flextronics and Sanmina-SCI, among others.

A couple of investment bank reports released by analyst covering the EMS sector recently opined on Pegatron. As our readers may recall. we published an earlier piece on ODM Wistron’s EMS offerings and standing in industry relative to Pegatron and Hon Hai. (See, also: Top 10 EMS / ODM company rankings, ratings, reviews)

To Pegatron‘s credit, the Company does promote itself as a Taiwan-based DMS provider. (Design, manufacturing services)

As one report suggests, considering Pegatron’s recent poor execution and lack of near-term catalysts derived from Pegatron 2Q11 financials, one analyst does not foresee much upside near-term.

But Wall Street aside, what does Pegatron want to be once the management turnaround takes hold? EMS or ODM?

Recent Pegatron sales increases were attributed to a 40% quarter-on-quarter and 54% quarter-on-quarter increase in sales in the computing and consumer electronics segments. As a result, writes Fubon Research, of a lower base in 1Q11 and the upcoming peak season for consumer products.

Meanwhile, revenue from the communication segment declined 6% compared to the previous quarter, caused by weak demand for CDMA iPhones.

Turnaround on the horizon?
Pegatron management’s proposed 3Q11 operating income turning positive seems to be a challenge, continues Fubon, partly due to the Company’s poor lack of vertical integration. But, read on. Hope remains.

Most Venture Outsource readers already know vertical integration is a contributing factor to an EMS provider’s success where scale, and size, can matter.

 

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Fubon also questions Pegatron’s struggling, and straddling, of EMS v. ODM business models and writes that because R&D resources are limited internal Pegatron, executive management and the board is in a dilemma in terms of allocating resources to either ODM-specific or EMS-specific projects.

Essentially, electronics product notebook design is like an ODM business model, but LED TV and iPhone assembly is more like an EMS business. The figure below provides a reasonable reflection of Pegatron’s business by segment.


Pegatron business by market segment


Meanwhile, Pegatron’s goal to run these two business models (EMS and ODM) is leading to internal conflict, in Fubon’s view, and management must find a solution to balance competing interests, which is why some on Wall Street believe is the reason Pegatron operating margins have not yet improved.

Pegatron’s 2Q11 sales was NT$104.8 billion. (Up 22% quarter-on-quarter, and up 1% year-on-year)

As we approach the peak season for consumer electronics products, Pegatron’s computing segment posted 40% quarter-on-quarter growth, and the consumer electronics segment grew 54% quarter-on-quarter, coming off of a lower base in 1Q11.

However, sales in the communication segment declined by 6% quarter-on-quarter because of weaker demand for the CDMA iPhone following 130% quarter-on-quarter growth in 1Q11.

Pegatron also reported net profit down 20% quarter-on-quarter and down 140% year-on-year in 2Q11.

Operating margin was –1.9%, which mostly matched revised-down market estimates writes Fubon.

Another report by Morgan Stanley goes on to state Pegatron’s margin erosion was mainly due to higher labor costs in China and component price increases in the computing and consumer segments. (See: 2011 Report reveals China manufacturing hourly labor rate, compensation costs impact EMS)

The Apple / Foxconn effect
For Pegatron’s other core business, Apple’s CDMA iPhone and new iPhone 4, Fubon estimates in its report Pegatron will ship 11 to 12 million units in FY11 and 15 million units (up 76% year-on-year) in FY12.

However, some on Wall Street believe Foxconn will continue to put price pressure on Pegatron over iPhone assembly orders.

Meanwhile, Pegatron still lacks solid vertical integration and has less experience in assembling Apple products than Foxconn has. This leads some to believe Pegtron will continue to have a low operating margin despite improving yield and utilization rates. Moreover, Samsung’s outsourcing orders with Pegatron are not scheduled to kick off until 2013, at the earliest.

Pegatron CEO Jason Cheng announced the Company has set up new tablet computing department, which is preparing for new customer orders in FY12.

 

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Some in industry feel this could be the Apple iPad 3.

In addition, Pegatron’s board of directors approved a capital expenditure increase for Avy Precision Electroplating (Suzhou) which could benefit vertical integration for new devices. Management also said it will continue investing heavily in mechanical components (~US $300 to 400 million in 2012 including metal casing enclosures) and plans to renew its old SMT lines (~US $100 to 150 million in 2012), which many believe could help Pegatron improve its cost structures and efficiency going forward.

Neither all good news, nor bad.

Pegatron’s success remains its to lose. Management has managed to work through challenges in the past. Perhaps these challenges the Company faces today are no different.




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