The electronics manufacturing services (EMS) companies have reported poor numbers in the first half of 2009. Their stocks have taken considerable beating so far. Despite significant revenue declines across the sector and continued softness in end-market demand, the industry's outlook has improved over the past few months due to improved liquidity and reduced debt levels. This article focuses on two good plays in the sector namely Flextronics International Ltd (NASDAQ:FLEX), and Celestica Inc. (NYSE:CLS).
Realigned global capacity likely to improve long-term profitability
The EMS industry has experienced rapid change and growth over the past decade. The demand for advanced manufacturing capabilities and related supply chain management services continues to escalate as an increasing number of original equipment manufacturers (OEMs) have outsourced some or all of their design and manufacturing requirements. Price pressure on EMS customers' products in their end markets has led to increased demand for EMS production capacity in the lower-cost regions of the world, such as China, India, Malaysia, Mexico, and Eastern Europe.
CLS and FLEX have responded by realigning their global capacity and infrastructure to optimize the operating efficiencies that can be provided by their global presence.
CLS Management announced restructuring program (amounting to $75 million–$100 million) during its 2Q 09 results call, which will increase utilization rates from the current approximately 50% to 60% levels and reduce fixed costs. Through the restructuring program, the company plans to shutdown less strategic sites in high cost geographies and concentrate on high-value businesses, with the aim of increasing operating margin to 3.5%-4%. The company expects to incur most of its restructuring expenses from the new plan in FY2010. Although the new restructuring program could squeeze margins in the short term, I believe the strategy of eliminating less strategic capacity will benefit margins over the long term and allow the company to become more resistant to business cycles.
On March 10, 2009, FLEX announced the restructuring plan intended to resize its business in order to return to more normalized operating margins as quickly as possible and align with customer requirements. Upon completion of these restructuring activities the company hopes to achieve savings between $230 million to $260 million from cost of sales through lower depreciation, reduced employee expenses, reduced operating costs and improved operational efficiencies, as well as reduced SG&A operating expenses.
Improving financial flexibility likely to reduce economic cycle effects
CLS and FLEX have also taken steps to improve their financial flexibility. For instance, few days back FLEX completed the sale of its equity investment and note receivable in privately-held Aricent for a total cash consideration of $255 million. This transaction has enabled FLEX to monetize non-core assets and benefit from the cash generated from those dispositions. The company has deleveraged approximately $1.4 billion last year, including $1.1 billion of debt pay-down and the reduction of A/R sales and securitizations by about $277 million. These strategic steps significantly improved FLEX's financial flexibility, while maintaining its cash balance over the last year at the approximate level of $1.7 billion. FLEX's recent deleveraging events also included the successful repurchase of approximately $200 million of both its 6.5% Senior Subordinated Notes and its 6.25% Senior Subordinated Notes, including a consent to modify the indentures for both notes, which was completed in the quarter ended on July 3. In addition, the company retired at maturity $195 million of its 0% Convertible Junior Subordinated Notes on July 31.
Positive outlook for global EMS market
The global EMS market is forecast to reach $260 billion in 2012. Asia-Pacific region is the largest and fastest growing regional EMS market. Asia-Pacific's EMS sales are estimated to reach $110 billion in 2010, while Europe, the second largest sub-market, stands second with $58.5 billion or 22.5% of the share. I believe, given the positive impact of operational and financial changes, CLS and FLEX would benefit from the positive outlook for the EMS industry.
