EMS: Victims of Wait-and-See Spending

Electronic manufacturing services companies still see weakness in some tech areas. S&P's Jawahar Hingorani says the pressure's on many players

An unknown looming over some technology stocks is how long it will be before businesses spend more on computers, software, storage, networking, and other gear. Storage maker Network Appliance (NTAP) recently reminded investors that some areas of spending are still on the weak side (see BusinessWeek.com, 5/24/07, "Hard Knocks for NetApp").

One early predictor of spending can be found by examining order trends at electronic manufacturing services (EMS) companies, which make many of the products that tech companies sell. "Their orders will slow down first," says Jawahar Hingorani, who follows EMS companies for Standard & Poor's Equity Research.

Spending on enterprise computing and storage is notably weak, consumer electronics is a bit slower, and telecom is a "mixed bag," Hingorani says. Meanwhile, spending on automotive components and industrial machinery is going up in the U.S., he says.

Take one look at this industry and you'll see the inactivity reflected in the stocks. The S&P Electronic Manufacturing Services index has dropped 1% this year through May 25, vs. a 6.9% rise for the S&P 500 index. In 2006, the industry fell 5.1%, vs. a 13.6% gain in the S&P 500.

Hingorani says the EMS group generates low operating profit margins—typically no higher than 4% to 5%—and is easily divided by the "have and have-nots." The laggards are characterized by operational difficulty and inventory problems—"They just can't get out of their own way," he explains. The successful ones have moved into low-cost manufacturing areas of Asia and have diversified into many areas such as medical technology, automotive components, and industrial machinery, and have a long history of good execution, he says.

BusinessWeek's Karyn McCormack spoke with Hingorani on May 25 about when he sees a recovery in tech spending and his opinions on EMS stocks. Edited excerpts from their conversation follow.

Note: Jawahar Hingorani is an S&P Equity Research analyst. He has no ownership interest in, or affiliation with, any of the companies on which he writes research. All of the views expressed here accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed.

There are still concerns about corporate spending on technology, as seen in NetApp's disappointing outlook on May 24. What's the trend in the EMS sector?

In March, tech companies that were customers of EMS companies said they were seeing a softer period, but their sales were not affected. But EMS companies had already started to see a slowdown. Plus everyone was expecting the economy would slow.

Now, as we've come through April and May, the customers of EMS have said that corporations are still taking a wait-and-see approach to spending on computers, storage, networking, and associated software. One side of the EMS segment is the telecom companies. We found that because of all the consolidation in the industry, there's also a wait-and-see approach to see which vendors will win.

When do you see a recovery in spending?

I think the December quarter is the earliest we'll see a resumption in enterprise spending because of the economy, and housing prices are down a lot. The interest rate picture is iffy, so we could see housing affecting consumer spending. [For] anyone that caters to consumers, [that] could lead to lesser spending and also more competition because companies are chasing fewer dollars.

What are the other challenges faced by the EMS industry?

Managing inventories and operations, and dealing with ordering patterns. EMS companies have to buy materials and build products, and then sometimes get caught between holding raw materials and end up holding finished inventory if an order gets delayed. Companies that do a good job of managing that, and negotiating better deals with customers, stand to do better than those who don't. EMS's operating margins are slim—they don't get higher than 4% to 5%.