A Decade of EMS - The Capital Markets' Perspective

Wow how times have changed for the EMS industry on Wall Street over the past decade. In 1999, Electronic Trends Publications estimated that the size of the global EMS industry was about $58B - by 2007 the industry hit $261B in sales. 

In 1999 the top three EMS providers headquartered in the US had total sales of about $8.8B (adjusting sales figures retroactively as is required to account for mergers structured as "Pooling of Interest" transactions). 

In that same year, these top three EMS providers were valued on Wall Street at an eye-popping $22B. Just one year later the combined sales of these three companies had exploded some 67% to $14.8B - while their combined market capitalization had ballooned 126% to over $50B. 








Figure 1: EMS market cap relative to sales - proxy measure


In 2000, at the height of the tech bubble, each dollar of revenue an EMS company generated raised its market cap by approximately $3.5. Back then it seemed as thought the good times and lofty valuations for EMS companies would last forever - but alas, it was not to be. By 2002, EMS companies were trading at a multiple of revenue of approximately 1, down from 3.5 just two years earlier. Today the average multiple of the publicly traded EMS universe is just 0.10 times revenue, down an astonishing 97% from its peak and down 96% over the past decade in more or less a straight line fashion. As the industry's sales have exploded more than 340% to $261B over the last 8 years, the market valuation of industry players has collapsed by 76% during that same period of time. One result of the collapse of valuations in the EMS sector has been the destruction of shareholder value on a massive scale.

"In 2000, the top 3 US headquartered EMS providers had sales of roughly $14B and a combined market cap of roughly $50B.

In 2008, the top 3 US headquartered EMS providers had sales of roughly $50B and a combined market cap of roughly $14B."

This steady decline in EMS market capitalization has been driven by a number of factors, the most significant of which being the decline in margins and earnings power demonstrated by the EMS industry at large. A decade ago the industry was characterized by gross margins in the range of 9% to 12%. Today gross margins average about half that level (see figure 2), with industry operating margins averaging about 2.2%. These operating margins are further reduced by the cyclical write-offs that tend to happen during recessionary periods when excess capacity is taken out of the overall EMS systems (these write-offs, even when mostly comprised of non-cash charges, tend to destroy shareholder's equity - see figure 3). This decline in margins in the EMS industry attests to a broad lack of pricing power by EMS players as OEMs more and more view their services as a non-differentiable commodity. Based on the current valuation of the US traded EMS industry at about $.40 on the dollar to book value, Wall Street clearly expects further margin compression in the short term.


Figure 2: EMS market cap/sales multiple relative to gross margins.


"Most publicly traded EMS providers in the world earn a return on assets and a return on equity that is far less than their cost of capital. When including one-time charges related to acquisitions, plant closings and asset impairments - the North American based EMS industry has not earned a single penny on a GAAP basis in the last ten years. In fact the industry has logged sales in excess of $480B during that time and has posted total GAAP earnings of approximately -$8B."

As OEMs have increasingly driven down EMS margins, Wall Street has largely abandoned the industry as "a place where capital goes to die a slow death." In the face of these low margins, many EMS providers have seen revenue growth as the key to driving shareholder value, adding capacity through both acquisitions and green field activities. As capacity has expanded, the cost of un-utilized or under-utilize capacity has increased dramatically, creating an oligopolistic price war on the larger pieces of OEM business such as computers and consumer electronics. As these larger pieces of business get awarded at operating margins ranging from -1% to +2%, the room for execution errors on the part of the EMS provider is effectively reduced to zero. With this increased sensitivity to execution risk in the EMS industry, most Wall Street analysts I speak to today consider the general risk reward profile inherent in the EMS model to be a less than compelling place to deploy capital.

But Wall Street's view of the EMS industry is not without a few bright spots. While the industry as a whole has gotten hammered of late, the valuations of smaller EMS companies have held up far better than those of their larger competitors. Companies like Benchmark, Plexus and Labarge continue to trade at a 2x to 3x multiple of sales premium over their larger competitors, although even these companies have seen relative multiple compression of 85% - 90% over the past decade. These companies have tended to carve out more profitable niches in the medical, industrial and military segments and have avoided the most commoditized OEM products segments such as computers and consumer electronics such as handsets. Over the past 12 months as industry operating margins have averaged just 2.2% - this triumvirate of small EMS providers has seen their operating margins average just north of 5%. And although making generalizations from too few data points is always risky, it is interesting to note that a regression analysis of Sales to Operating Margins of 8 publicly traded EMS providers in the US shows a strong negative correlation between profitability and size (r2= -0.54), supporting Wall Street's current view of smaller players. As is the general trend in equity investing, Wall Street continues to value specialists EMS companies over EMS companies it sees as more broadly focused.


Figure 3: GAAP Retained Earnings - Top 3 US EMS Companies


So what can be inferred from the long term trend in EMS company valuations and what does it mean for the future of the industry?? With pre-tax return on assets in the industry (measured on a GAAP basis) averaging less than the yield on the 10 year treasury for over two years now - will the industry remain shut off from equity funding for the foreseeable future? Or will the structural write-offs in this worst cyclical downturn in 80 years take enough capacity out of the system to allow for broad margin expansion that attracts new equity capital?? I will address these and other issues in my next article where I will peer into my crystal ball and attempt to predict the future of the EMS industry - and perhaps the future of San Francisco Giants 2009 season as well.

Note: This is the first in a series of articles that will look at the history, and the future of the EMS industry.

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