got capacity - ems industry by dsheffield

8/2/2019 Got Capacity - EMS Industry by Dsheffield

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TABLE OF CONTENTS

Cover Page 1

Table of Contents 2

Executive Summary 3

Industry Analysis: Electronic Manufacturing ServicesIndustry Overview 4Key Industry Players 4

Solectron Corp. (SLR)Flextronics International (FLEX)

Celestica, Inc. (CLS)SCI Systems, Inc. (SCI)

Brief History 6

Recent Trends 7OEM OutsourcingConsolidation and Integration

Expansion of ServicesInventory Levels

Cost Reduction StrategiesAbility to Attract Capital

Industry Risks and Mitigants 10Capital Intensive

DiversificationCyclicality and Seasonality

CompetitionPorter Analysis 13Banking Opportunities 14

Working Capital LOC

Acquisition FinancingGuidance CapEx Facility

Treasury Management ServicesForeign Exchange

Interest Rate HedgingEquipment Leasing

Outlook / Conclusion 16

Industry Terms 17

Bibliography 18

Exhibits 19


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EXECUTIVE SUMMARY

Electronic Manufacturing Service (EMS) providers fabricate electronic systems andsub-components for Original Equipment Manufacturers (OEMs) such as Intel, SunMicrosystems, Hewlett Packard, etc. Due to intense competition, top-tier EMS vendorsare involved in a number of service areas that technically fall out of the box of traditional

manufacturing. For instance, EMS providers have begun layering more value-addedservices into daily operations, including, product design collaboration, prototypedevelopment, and even end market support. Ultimately, the OEM wants its designquickly transformed into a product, ramped into high-volume production, and releasedbefore its competition to gain increasing market share. By offering a total solution, EMS providers are able to differentiate their capabilities and create incentives for futurebusiness with OEMs. The bottom line for EMS vendors is that they are challenged withadding value to the supply chain in order to gain OEM outsourcing projects. EMS firmstypically compete either to be the low cost provider, offer superior product quality orhave sufficient manufacturing capacity and ability to shorten the OEMs time-to-market.

Some recent trends impacting the industry include:(1)Increased OEM outsourcing at record levels during the interim;(2)Continued consolidation;(3)Expansion of core services provided by the EMS vendor;(4)Aggressive cost reduction strategies to adjust for softening end market demand; and(5)Uncertainty about EMS firms ability to attract capital in a weakening market.

In todays evolving technology market, manufacturing technologies are becoming moresophisticated and OEMs are facing growing challenges, including shorter product lifecycles, a continuous need to reduce costs, and intense competition. By outsourcing itsmanufacturing, OEMs are able to recognize a number of benefits such as: reduced

CapEx; lower production costs; improved time-to-market; increased focus to concentrateon core competencies; and greater flexibility.

The EMS provider segment is highly fragmented with the top six firms accounting for53% of total revenues. Based on FY 2000 revenues, the EMS segment is a $101Bindustry, which represents a 13% penetration into a total $772B market available. Eventhough technology as a whole exploded, EMS penetration has remained relatively flatover the last three years. EMS providers continually seek to gain greater penetration intoOEMs outsourcing projects.

Despite the recent announcements, the bear market may be more positive for EMS

providers. During boom times when profits are high and access to capital is abundant,OEMs have less motivation to outsource or divest of its manufacturing capabilities. Incontrast, todays current market and economic conditions could allow EMS firms to gaina stronger footprint into OEMs cost of goods sold. In fact, Bear Stearns reports thattoday quote activity on new outsourcing contracts is at an all-time high.

This analysis seeks to provide insight into current industry trends, key players, inherentrisks and mitigants unique to EMS providers, drivers impacting the industry, andpotential banking opportunities for Wells Fargo.


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INDUSTRY OVERVIEW

FY 2000 revenues for Electronic Manufacturing Services (EMS) industry totaledapproximately $101B for a 13% penetration into a total $772B market available, whichrepresents the cost of goods sold by OEMs. Total repair and warranty market availabletotals $100B, of which EMS companies have only penetrated 1%. While the industry has

grown in terms of total dollars, EMS providers continually seek to gain greater penetration into OEMs outsourcing projects. Despite the technology boom, penetrationhas remained relatively flat over the last three years. For example, the total EMS marketfor FY 1998 totaled $80B, representing a 13% penetration of a total $627B. EMS firmsseek to differentiate themselves by being a lower cost provider, supplying superiortechnology, or having sufficient capacity to reduce the OEMs time-to-market.

EMS Providers vs. Dow Jones Avg. (12 mo.)

KEY INDUSTRY PLAYERS

The EMS provider segment is highly fragmented with a number or smaller companiesand 15-20 larger companies. With consolidation, the industry is becoming more like anoligopoly with a few key, top-tier players that dominate the industry. As evidenced bythe following pie chart, the top six firms account for 53% of industry revenues for FY2000. The classification of top-tier EMS providers ranges from the top seven to tencompanies in the industry, depending upon the research analysts opinion. This analysis

focuses primarily on the top four EMS companies by FY 2000 revenues. The followingchart illustrates that Solectron is unquestionably the #1 EMS provider in both sales andmarket capitalization; however, after SLR, there is some debate as to who is #2.

EMS IndustryTop 5 by FY 2000 Revenues Top 5 by Market Value as of 6/14/011. Solectron - SLR $19.5B 1. Solectron SLR $12.6B2. Celestica CLS $9.8B 2. Flextronics FLX $9.4B3. SCI Systems SCI $9.1B 3. Celestica CLS $9.0B4. Flextronics FLX $6.9B 4. Sanmina SANM $6.8B5. Sanmina SANM $4.5B 5. Jabil Circuit JBL $5.0B


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Solectron Corporation

Solectron Corporation, based in California, is an Investment Grade, Fortune 500company that furnishes integrated supply-chain solutions that span the entire product life-

cycle from technology solutions, to manufacturing and operations, to global services.Solectrons customers include Cisco Systems, Compaq, Ericsson, Hewlett-Packard, IBMand Nortel Networks. The companys core competency is its PCB assembly. For thequarter ended 6/1/01, Sales were $4B, up 9.3% from prior year-same quarter, butrepresenting a 26.5% decrease from $5.4B in the 2Q of fiscal 2001. Solectron incurred anet loss of $186MM. Excluding restructuring charges, the company had third-quarterearnings of $5MM. As of 2/1/01, SLR maintains good liquidity (2.55:1 current ratio) andmoderate leverage (47.3% debt-to-cap & funded debt to trailing 4Q EBITDA of 3.87x).

Flextronics International

Flextronics International Ltd., based in Singapore, provides complete product design

services, including electrical and mechanical, circuit and layout, radio frequency and testdevelopment engineering services. The Company takes responsibility for engineering,supply chain management, assembly, integration, test and logistics management. FLEXfocuses primarily in the telecommunications, networking, and consumer electronicsindustries. Flextronics customers include Cisco Systems, Ericsson, Hewlett-Packard,Lucent, Microsoft, Motorola, Nokia, Palm Computing and Philips. FLEX has moreexposure to consumer products than its peers, which is important to monitor during thedownturn. Telecom has experienced a greater consumer demand drop-off than mosttechnology sectors. For FY 2001, net sales were a record $12.1B, up 74% from the prioryear (Gross Margin 8.0%). Cash net income before amortization and one-time chargesfor the year increased 97% to $416MM. As of 12/31/00, FLEXs liquidity was less than

its peers (1.47:1 CR), though it demonstrated lower leverage (36.2% debt-to-cap). Thecompany was also able to lower its funded debt to trailing 4Q EBITDA from 3.09x at12/31/00 to 2.20x by 3/31/01, as FLEX used a portion of funds from equity offerings toreduce debt.

Celestica, Inc.

Celestica, Inc., headquartered in Toronto, manufactures, assembles and tests complexPCBs, primarily on a build-to-order basis. CLS' services includes design, componentselection and procurement, prototyping, product assurance, assembly, test, failure


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analysis, full supply chain management, worldwide distribution and after-salessupport. Celestica focuses on communications through recent acquisitions and a partnership with Sagem SA. For the three months ended 3/31/01, revenues increased67% to $2.7B (GM 6.4%), while net income totaled $54.8 million, up from $26.1MM ayear ago. Revenues increased through growth in communications, servers and storage,while net income reflects improved gross margins and higher interest income. At

12/31/00, Celestica maintains adequate liquidity (2.00:1 CR), while being significantlyunder-levered compared to its peers (0.04% debt-to-cap). CLS capital structure differsfrom its competitors in that the company has a greater portion of short-term currentliabilities as opposed to long term funded debt. On 6/7/01, Celestica was selected the #1technology company byBusiness Weekin its Tech 100.

SCI Systems, Inc.

SCI Systems, headquartered in Alabama, is an Investment Grade, Fortune 500 companythat designs, manufactures, distributes and services electronic products for virtually everymarket segment. SCI recently announced its plans to triple the size of its existing plant inKunshun China. The Companys traditional core competency has been its focus on PCs

and related equipment. For the nine months ended 3/25/01, net sales rose 10% to $6.64B(GM 3.7%), while net income fell 28% to $100.7MM. Operating results reflect animproved product mix, which is offset by a $59MM charge for the plantconsolidations/closures. As of 3/31/01, SCI maintains adequate liquidity (2.04:1 CR),and is slightly more levered than its peers (49.7% debt-to-cap).

Debt Ratings As of 6/18/01Senior Unsecured S&P Outlook MoodysSolectron SLR BBB Negative Baa3SCI Systems SCI BBB Negative Baa3

Celestica CLS BB+ Stable Ba2Flextronics FLEX BB- Positive Ba2

Industries Served(% of 1Q01 Sales)

Solectron Flextronics Celestica SCI Systems

Telecom 33% 32% 31% 33%Networking 32% 17% 15% -PCs / Medical 21% 6% 7% 40%Servers / Peripherals 11% 30% 33% 19%Other 3% 15% 14% 8%Source: Morgan Stanley Dean Witter, Bear Stearns, & www.celestica.com.

BRIEF HISTORY

Approximately 30 years ago, OEMs used EMS vendors to provide additionalmanufacturing capacity only during peak demand periods. The OEMs engineers woulddesign the product and delegate it for high-volume production. These projects wererelatively short-lived, with little cooperation between the OEMs and EMS providers. Towin project bids, EMS vendors had to demonstrate immediate capacity availability andthe lowest manufacturing cost.

Then during the 1980s, the electronics industry exploded, and OEMs were forced tooutsource more of their manufacturing volume on a regular basis. As a result, OEMs began to form stronger relationships with EMS providers and realized that low cost


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should not be the only reason to choose an outsourcer. The OEMs focus for products built by a third party began to shift to quality, technical capabilities, manufacturingcapacity, and service.

By the early 1990s, the level of automation increased, along with the complexity of products, and OEMs could not keep up with the ever-changing improvements in

technology and the state-of-the-art manufacturing skills needed to produce their own products. However, EMS providers continued to develop these skills, upgrademachinery, and improve manufacturing capabilities. In general, OEMs realized the valuecreated by EMS vendors and opted to outsource more manufacturing capacity. As aresult, OEMs continued to strengthen their relationship with EMS firms and focus moreon their own core competencies, including product development and marketing.

Today, EMS providers have evolved into full-service manufacturers, offering design,procurement, inventory management, and distribution services.

RECENT TRENDS

OEM OutsourcingIn todays evolving technology market, OEMs face increasing challenges includingshorter product life cycles, more technologically advanced products, a continuous need toreduce costs, and intense competition. By outsourcing its manufacturing, OEMs are ableto recognize a number of benefits including (1) reduced CapEx; (2) lower productioncosts; (3) improved time to market; (4) increased focus to concentrate on corecompetencies; and (5) improved flexibility.

Reduced Capital Expenditures: Top-tier EMS providers continuously invest instate-of-the-art manufacturing equipment, which enables the OEM to cost effectively

stay on the cutting edge while reducing its own CapEx requirements. Lower Production Costs: Due to efficiencies gained with increased production

volumes, greater capacity utilization, and lower material procurement costs, EMSproviders are typically able to pass cost efficiencies on through to the OEM.

Improved Time-to-Market: Rapid technological change has shortened product lifecycles, making it imperative for OEMs to accelerate the product development processand time to market. As a result, virtually all top-tier EMS vendors provide front-endservices such as design, engineering, prototype, and pre-production services.Moreover, EMS firms are able to provide these services more efficiently and costeffectively than the OEM.

Increased Focus on Core Competencies: By outsourcing its manufacturing process,

OEMs are able to direct more focus on core competencies like product developmentand marketing. OEMs are more dependent on EMS providers to manage the entiresupply chain. This combination enables products to be introduced faster and morecost effectively. Concurrently, EMS vendors revenue growth accelerates and theOEMs improve their balance sheet and expand margins.

Improved Flexibility: EMS providers generally run their operations to achievemaximum flexibility, which means that production lines can be quickly re-tooled andre-tasked for new product programs as capacity becomes available. Plus, most largeEMS firms operate in many locations around the world. Therefore, manufacturing


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projects can be moved relatively quickly to a location that has a more attractivecost structure or closer proximity to the end-user. In addition to location flexibility,EMS providers also offer design and volume flexibility to accommodate anynecessary manufacturing or product changes.

Consolidation and Integration

The EMS industry has experienced a wave of consolidation driven partly by the OEMs

desire to establish close working relationships with a select group of manufacturers andEMS providers need to reach the critical mass to gain economies of scale, broaden theircustomer base, and strategically position themselves for future business opportunities.

Over the last several years, acquisition and asset divestiture activity within the industryhas been accelerating, even despite the overall slowing economy. The activity has beenrelatively split with about half fitting into asset divestitures and half into acquisitions. Inthe near future, this trend appears that it will continue. The acquisition front is drivenmore by the need or desire of EMS firms to control more of the supply chain and toexpand geographically, while divestitures are driven more by the OEMs.

Another driver for consolidation is that managers for EMS vendors are attempting tooffset current volume reductions from existing customers with new program bids and / orOEM asset divestitures. Aggressively moving forward with vertical integration during aslowing economy could present potential problems for EMS firms, especially if the M&Aare financed more with debt as opposed to equity.

Recently:

On 6/15/01, Celestica announced that it has entered into a stock-for-stock exchange withOmni Industries Limited, an EMS provider headquartered in Singapore. Omni Industrieshas a broad-based presence in Asia, as wells as operations in the U.S. and Mexico. Omni


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provides PCB assembly and other related supply chain capabilities including plasticinjection molding, IC equipment, substrates and distribution. Omni shareholders will beable to elect to receive cash, instead of CLS shares, in respect of some or all of theirOmni shares up to a maximum of $860MM cash.

On 5/31/01, Celestica announced that it has entered into a stock-for-stock exchange

agreement with Primetech Electronics Inc., an EMS provider based in Kirkland, Quebec.Total consideration is Cdn.$265MM.

On 5/29/01, Solectron said it has acquired Cisco Systems', Dense Wave DivisionMultiplexing (DWDM) and optical add/drop module manufacturing capabilities locatedin West Columbia, S.C. SLR expects to move the operation to the company's East Coastoptical center in Charlotte, N.C.

A risk to M&A activity is the EMS firms ability to integrate the target into ordinaryoperations. Moreover, the company may have additional borrowing needs and place agreater strain on future cash flow if it pays a premium for the acquisition. It is also

important to determine the useful life and true value of the assets purchased in adivestiture. If the recently acquired assets were not maintained at a high quality, theEMS vendor may have to extend additional resources to bring these assets up to fulloperational capacity. Given the increasing level of automation and state-of-the-artmanufacturing techniques, it is also important to gauge whether the computer systems arecompatible and if additional expenditures are necessary to integrate its systems.

Expansion of Services Offered by EMS CompaniesEMS providers have begun layering more value-added services into their operations,including, design collaboration, prototype development, delivery, and end marketsupport. When an OEM partners with an EMS provider, the OEM wants its design

quickly transformed into a product, ramped into high-volume production, and releasedbefore its competition to gain increasing market share. By offering a total solution, EMSproviders are able to accelerate their current revenues, differentiate their capabilities, andcreate incentives for future business with OEMs:

Full Life Cycle Service Top-tier EMS vendors are involved in service areas thattechnically fall out of the box of manufacturing. For example, when the OEMspecifies the component structure and functionality of a new circuit board, the EMSprovider is typically best able to recommend the right power supply for that design.After prototype design, the EMS vendor often provides manufacturing of a smallnumber of prototype units, which is generally a higher-margin business for the EMS

provider. After volume manufacturing has been introduced, packing and dropshipping are also added, and some EMS firms even offer on-sight customer support.By offering services that span the full life cycle of a product gives the OEM anincreased incentive to work with a specific EMS company.

Supply Chain Management Supply Chain Management allows the EMS providerto be the low cost and high volume producer of a product program for an OEM, byleveraging its economies of scale and information technology. Because of theirability to buy in larger volumes than the OEMs, EMS vendors typically find the betterdeals in the component market, which in turn are passed on to the OEM. Using EDI


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technology, the EMS provider pulls together all of its services and products fromthird-party suppliers and integrates the demand and supply horizons of both theircustomers and suppliers to create Supply Chain Management value.

Inventory LevelsInventory levels have steadily increased as a result of continued slowdown in the IT

channel. The main driver behind the build up is the end-market demand softening.Therefore, OEMs and EMS providers are left with abnormally high inventories ofcomponents and work in progress in the channel, which has eroded earnings andincreased the operating cash flow burn rate. Given the magnitude of build up, industryanalysts project that the earliest recovery will not occur until at least 4Q01 or later.Furthermore, as capacity utilization falls and prices erode, gross margins are experiencingsignificant deterioration.

Cost Reduction Strategies

Decelerating end-market demand can typically be offset by an increasing in OEMoutsourcing (currently 13%); however, the speed and magnitude of the recent drop-off in

orders has outpaced the speed at which EMS providers have won new outsourcing bids oreven the speed at which they can cut back costs and overhead. To address this demandsoftening and the high cost structure, several larger EMS providers are undertakingaggressive cost reduction strategies. For example, Flextronics announced its plans toreduce manufacturing capacity by 15% or 3 million square feet, and reduce headcount by10%. For the most recent fiscal 4Q01, Flextronics recognized an after-tax charge of$276MM, primarily related to asset impairment, severance packages, and exiting leaseobligations. In a similar move, Solectron announced its plan to incur non-recurringcharges between $300MM-$400MM, relating to reducing its workforce by 8,200employees, plant closings and restructuring by the quarters end. Likewise, SCI Systemsrecently reduced its employee headcount by 15%.

Ability to Attract Capital

EMS providers have historically demonstrated an ability to access capital from bothequity and debt markets. In fact, a number of acquisitions and asset purchases have beenfinanced through secondary equity offerings and stock-for-stock exchanges. Forexample, on 5/29/01, Celestica issued a subordinated offering netting the company$705MM. Further, on 3/12/01, SCI Systems completed $600MM private placement tofinance CapEx. Plus, on 6/18/01, Solectron filed a $3B shelf offering.

However, in its March 2001 Technology Outlook, Merrill Lynch announced, Tech is ina bear market.1 Due to softening in demand from end-markets, inventory build up,

marginal returns, and the high cost structure of EMS providers, Raymond James asserts,investors are still hesitant and looking for the sign that we (Technology) have made aclear bottom in the fundamentals and some proof that conditions are improving.2 Giventhe capital intensive nature of its business, EMS companies strive to gain economies ofscale through acquisition, and sacrifice short-term profitability. This strategy, which may

1Steven Milunovich and Michael Ramirez , Merrill Lynch TechStrat Picture Book p. 2.

2Shawn Severson, Raymond James Electronics Supply Chain p. 3.


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pay dividends for the company and its investors over the long term, also may limit thecompanys ability to access equity and debt capital during a bear market.

INDUSTRY RISKS & MITIGANTS

Capital Intensive

Manufacturing technologies are becoming more sophisticated and complex. Top-tierEMS providers continuously invest in state-of-the-art manufacturing equipment and seekto gain economies of scale. The bottom line is that the EMS vendor has to have theavailable capacity to take on new projects and handle the increasing volume requested bythe OEMs. These strategies are very capital intensive and require EMS firms to directsignificant resources to achieve desired results.

CapEx Requirements EMS providers have sizeable maintenance and replacementCapEx requirements. In order to continually win bids from OEMs, the EMS firmmust keep its manufacturing machinery, equipment and facilities current with themost recent technology, while maintaining desired capacity to handle requested

volume. Most top-tier EMS vendors have historically accessed capital from theequity and debt markets to fund these expenditures. It is important to monitor thecompanys debt-to-capitalization to ensure the EMS provider does not over-lever itsbalance sheet to fund CapEx.

SCI SLR FLEXDebt-to-Cap 49.7% 47.3% 36.2% As of: 3/31/01 2/1/01 12/31/01

High Fixed Cost Structure In addition to its sizeable CapEx requirements, EMSfirms have a high fixed cost structure due to their business model. Therefore, EMSproviders seek to gain sufficient volumes to create economies of scale. This high coststructure arises from the overhead needed to operate the machinery and equipment,

related maintenance to keep it in top working order, the sizeable interest on debt andoperating leases, plus the notable depreciation. When demand softens, this high coststructure quickly erodes earnings. As a result, most EMS vendors are scaling backtheir workforce, trimming CapEx and reducing capacity.

DiversificationOf all the industry risks, diversification may be the most critical. Despite the low penetration of EMS of overall cost of goods sold and the growing trend towardoutsourcing manufacturing, a number of different factors can go wrong to create abusiness slowdown for an under-diversified EMS provider. There are four basic areas inwhich EMS firms need to diversify: (1) by industry, (2) by customer within industry, (3)by product and technology category, and (4) by manufacturing location.

Industry diversification Industry diversification ensures maximum productioncapability all year round. The major industries that use EMS include telecom andnetworking equipment, personal computers, workstations, servers and mainframes,computer peripherals, and other electronic industries (medical, industrial, consumer).SCI and Solectron have the most diverse customer bases, with no sector contributingmore than 45% of revenue.


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Customer diversification Company diversification allows EMS providers togenerate revenue from multiple companies within an industry. As OEMs continueoutsourcing, EMS firms build core competencies in manufacturing products for agiven industry, which results in more successful program bids. For instance, an EMSvendor could potentially manufacture similar products for Lucent, Nortel, andEricsson at the same time.

Product and technology diversification Product diversification protects the EMSprovider from short product life cycles, obsolescence, and development delays. Forexample, when PCs entered the corporate mainstream in the mid 1980s, EMSproviders partnered with major PC manufacturers like Compaq, Dell, and IBM. SunMicroSystems, a unix-based company, refused to adopt the WinTel standard. Withthe emergence of the Internet in the mid 1990s, Sun enjoyed a resurgence and evenoutgrew many of the leading PC companies over several years. Sun has also been alongstanding customer of multiple EMS vendors. By partnering with Sun evenduring some of its leaner years, EMS firms were able to enjoy a resurgence of growtheven as some PC manufacturers fell on hard times and slowing growth.

Geographic diversification Geographic diversification can partially cushion the

impact from an economic downturn or any natural disaster that may occur in any oneparticular area of the world, plus it can help the EMS provider locate within closer proximity to its customers and ultimately, the end-users. Therefore, EMS vendorsattempt to establish production plants in areas of high customer concentration orwhere manufacturing efficiencies, such as low labor cost, can be achieved. EMSfirms with diverse geographic locations are better equipped to address OEMs' needsfor low-cost production, expeditious shipping, and local requirements in specific endmarkets.

Cyclicality / Seasonality

During the last half of the 1990s, the technology sector and overall domestic economy

exploded so much so that many investors lost site of the industrys cyclicality. MerrillLynch quips, Weve been concerned that the factors reinforcing the cycle on the way upwould reverse and wreak havoc on the way down.3 With softening demand from endusers, increasing inventory build up both at the OEM and EMS level, negative earningsreports and industry-wide lay offs, the industry is definitely experiencing a down cycle.The question is how much worse it can get and when do we come out of it.4 Industryanalysts differ on when the potential turning point in the cycle may come.

In addition to cyclicality, some tech industries demonstrate more seasonality. Forexample, because of the heavy consumer component in the computer/peripheralsindustry, OEMs expand contracts with EMS providers typically during the holiday

season. Once the holiday rush has been satisfied, the EMS vendors' manufacturing linescan be re-tasked for another industry. As noted earlier, diversification can partiallymitigate an EMS firms exposure to cyclicality and seasonality.

The following chart demonstrates four key OEMs (that outsource to EMS) performancevs. the Down Jones Industrial Average over the last twelve months. Compare this chart

3Merrill Lynch p. 2 .4Merrill Lynch p. 2.


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to that on page 4 and note that EMS providers have been slightly less impacted by thecurrent downturn than OEMs.

OEMs vs. Dow Jones Avg. (12 mo.)

Competition

The EMS industry is highly competitive, as evidenced by the volume of M&A activitycombined with the aggressive bidding process to win OEM outsourcing projects. For fulldiscussion of this risk, see the Intensity of Rivalry Among Competitors in the PorterModel section.

PORTER MODEL

Threat of New Entrants Low /ModerateWhile there are a number of smaller EMS competitors, this analysis focuses on thelargest, top-tier firms. Given the sizeable capital requirement and cost of capital it wouldtake to break into the top five (over $5B) and current market conditions (investorsuncertain), the threat of new entrants to this industry is relatively low. Plus, one of themost tangible elements EMS providers offer is their experience and expertise in supplychain management. EMS firms are generally able to command lower pricing whenprocuring materials, even lower than OEMs. This adds real value to the supply chain andis only possible through the EMS vendors established relationships and contacts. Thisknowledge of the distribution chain would be very difficult for a new entrant to duplicate.Moreover, given the highly proprietary nature of the technology and the speed required to

get to market, OEMs prefer to deal with relatively familiar, stable EMS providers.

It is conceivable that a group of smaller EMS firms would consolidate and create a newcompany to compete against the top-tier companies. However, with current marketconditions and the uncertainty of investors, the cost of capital for a group of smaller EMSfirms to pull this off may render this scenario unlikely.


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Threat of Substitutes High/Moderate

For FY 2000, EMS revenues represented only a 13% penetration of a potential $772Bmarket. Therefore, the other 87% (substitutes) that EMS firms compete against are theOEMs themselves, who manufacture a majority of products in-house. Given the lowpenetration rate, this threat is considered high to moderate. While overall revenues have

grown, EMS vendors are continuing to struggle to gain a greater footprint into the OEMsoutsourcing. Put another way, the overall Technology pie (total revenues) has grown,while EMS share of the pie has remained relatively the same. EMS penetration hasaveraged only 13-17% since 1998, compared to various analysts projections of 25-32%for FY 2001. Because the market for their services has increased, the potential exists forEMS firms to gain greater penetration. Moreover, in a recent opinion on Solectron, BearStearns notes that new outsourcing contracts are at an all-time high. Only time will tell ifthis current outsourcing rate is sustainable.

Intensity of Rivalry Among Competitors High

As evidenced by continued consolidation, rivalry among existing EMS firms is high.

Acquisitions by top-tier EMS providers and divestiture by OEMs is driven by the need toreach economies of scale. Due to the capital intensive and high cost structure of theindustry, EMS providers need both capacity and volume to break even and generateadequate returns for investors. End user demand has softened, which has increasedinventory and lowered orders requested by OEMs (see Exhibit 2). To address this, EMSproviders have sought to increase volume primarily through M&A and strategic alliances.Schroder & Co. notes the potential problem with this strategy is that, assets that are upfor sale tend to be ones that are under-supported and underutilized (those are often thecircumstances that lead to the divestiture in the first place).5 Therefore, the acquiringEMS firm may be forced to extend even more resources to get the newly acquired assetsin top working condition before they are brought on-line.

Moreover, bids among EMS providers for OEMs manufacturing business is highlycompetitive. In order to win bids, EMS firms must differentiate themselves as either alow-cost provider, higher quality producer with superior technology or manufacturer withsufficient capacity and availability to generate a quicker time-to-market for the OEM.

Bargaining Power of Buyers (OEMs) Moderate/High

As previously noted, one of the key attributes EMS firms offer is its supply chainmanagement, including materials procurement. Since this process adds real value in theterms of lower margins, this gives EMS providers a bargaining chip in the negotiation ofbids with OEMs. This risk, though, is rated moderate to high since OEMs still control

87% of manufacturing and thus, have greater bargaining leverage.

Bargaining Power of Suppliers Low/Moderate

Selecting and purchasing the best-fit, most cost-effective raw materials is a critical step inensuring high-quality, rapid production and on-time delivery of products. EMS firmshave established relationships with a many vendors and command better prices for raw

5Stephen Koffler and Lori Franklin, Schroder & Co. Inc. p. 15.


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materials. Even if the price of raw materials increases, EMS companies will be able tonegotiate the best price due to the volume they provide their suppliers.

BANKING OPPORTUNITIES

Wells Fargo has provided lending and cash management services to a number of EMS

providers prior to their IPO. And today, WFB continues to have a number of bankingservices and opportunities that add value to its customers and strengthens existingrelationships. The following is not meant to be an all-inclusive list of services WellsFargo can provide, but rather highlights a few areas where the Bank can differentiateitself with its customers.

Working Capital LOC

As previously identified, EMS providers have specific needs for working capital, whichmay be seasonal. The most basic banking service Wells Fargo can provide its customersis working capital lines. The Bank has the sophistication to incorporate the customerstreasury management needs and accordion features to meet EMS firms seasonal working

capital requirements with this product. For example, Wells Fargo may offer an EMScompany a $100MM LOC that expands to $150MM for only three months to providesufficient back-up liquidity during peak production. Another viable option may be forthe Bank to extend short-term, uncommitted bid lines to the company. Funds advancedhave a shorter tenor and can also provide additional working capital as needed. Eventhough the bid lines are uncommitted facilities, they can potentially provide more risk iffunded and the EMS firm is unable to repay the loan within the short maturity.Therefore, Wells Fargo would only consider extending this type of facility for the morefinancially stable, top-tier EMS provider.

Acquisition Financing

It appears the M&A trend will continue, at least through the short-term. While a numberof these acquisitions and asset purchases have been financed through secondary equityofferings and stock-for-stock trades, bank financing may appeal to EMS providers as analternate source of capital as the equity market dries up during the current economicslowdown. The risk versus reward to Wells Fargo for providing this service may pricethe Bank out of this market. The risk of this type of financing to the Bank is that acustomer may over-lever its balance sheet or pay too much, which may increase fixedcosts, thereby straining future earnings, cash flow and liquidity. Most of WFBswholesale customers listed as non-accrual (as of March 2001) ended up there as a resultof failed acquisitions. While this type of financing poses a number of risks, the Bankwould entertain this type of financing opportunity for the right customer and given an

appropriate return for the inherent risks. The Bank may be limited, though, from fundingnew debt by the security agreements of existing senior and subordinated notes.

Guidance CapEx Facility

EMS providers have to allocate significant resources to make annual capital expendituresto upgrade equipment and to remain current with the state-of-the-art technologicaladvances. Wells Fargo has an opportunity to provide its customers with guidance CapExfacilities for either one-time asset purchases or guidance lines for continual maintenanceneeds. This type of lending is more risky than providing traditional working capital


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financing, especially if it is for project specific financing. However, if the EMScustomer has relatively low leverage, good liquidity, consistent earnings and sufficientcash flow, the Bank may consider this type of facility, including the proper controls priorto funding.

Treasury Management Services

Wells Fargo can and will continue to offer integrated treasury management services toEMS firms and their multi-tiered organizations. Given the extensive working capitalneeds previously discussed, the Bank may utilize its TM services in conjunction withworking capital lines to maximize the customers cash position. In addition, Wells Fargooffers ACH, Internet ACH, Wire Transfer, ZBA, investment and credit sweep, controlleddisbursement, cash concentration, cash vault services, and Purchasing Card. Theautomation these services allow the EMS customer to focus on its core contractmanufacturing process and pass along additional cost savings to the OEMs.

Foreign Exchange

Since most Top-tier EMS providers operate globally, they are subject to the volatility of

multiple currencies. WFB can provide these companies several options including advisedand unadvised F/X lines to purchase foreign currency or enter into forward contracts asneeded. Plus, given EMS companies specialize in global materials procurement, theTrade Bank, through its alliance with HSBC, may be able to lower the customers cost ofimporting or exporting materials and end products.

Interest Rate Hedging

A majority of the publicly traded EMS companies are exposed to interest rate riskthrough fixed rate senior and subordinated notes. The Bank can offer these customerssome protection against this risk through interest rate hedging products. Wells Fargooffers a number of solutions, which can be tailored to each customers individual need,through any combination of collars, swaps, and floors.

Equipment Leasing

In todays rapidly changing technology sector, EMS providers differentiate themselvesthrough their state-of-the-art manufacturing facilities. This capital intensive model isdriving the need for equipment leasing, as the ability to quickly re-tool and re-task is at a premium. Moreover, advanced technology and increased automation acceleratemachinery obsolescence. Wells Fargo can offer EMS customers equipment leasing as anoption, which can provide off-balance sheet financing and the flexibility to more quicklyexchange machinery and tolls, as opposed to purchasing.

OUTLOOK/CONCLUSION

The current short-term outlook for EMS and technology, in general, is uncertain. On6/18/01, Solomon Smith Barney announced that it had reduced earnings estimates for theentire industry and projects that, it will not be until FY 2004 that Tech(nology stocks)recovers to FY 2000 record levels.6 Raymond James notes, the focus should be ondetermining if we are enduring a simple inventory correction or a more severe situation

6MSNBCs Market Watch on 6/18/01.


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stemming from last years asset bubble in the equity market, which could take years toresolve.7 Merrill Lynch reduced its FY 2001 capital spending budget estimate for techby 20%. Despite the recent announcements, the bear market may be more positive forEMS providers. For three years, analysts that follow this industry have said that EMSfirms would gain a greater market share of outsourced manufacturing from OEMs.However, to date, EMS penetration has only averaged 13-17% since 1998, compared to

32% projection for FY 2001.8 As a result of the negative earnings releases, investors are becoming increasingly uncertain, which may lead to an increase in the cost of capital.Therefore, it is plausible that OEMs may look more to outsourcing or divesting ofmanufacturing divisions as a short-term way to boost earnings, opening the door for EMSproviders. During boom times when profits are high and access to capital is abundant,OEMs have less motivation to outsource or divest of its manufacturing capabilities. Incontrast, todays current market and economic conditions could allow EMS firms to gaina stronger footprint into OEMs cost of goods sold. In fact, Bear Stearns reports, quoteactivity on new outsourcing contracts is at an all-time high, and we believe this will resultin enormous incremental revenue through new multibillion-dollar annual contracts fromOEMs like NEC, Hitachi, Sony, Alcatel, and Nokia.9

Given the competitive market conditions and continued M&A activity, it will beincreasingly important to gauge EMS providers liquidity, leverage, earnings and cashflow and compare each companys financial strength to its peers. It may be tempting forEMS firms to over-lever their balance sheet to gain market share and economies of scale,which could strain earnings and cash flow. This will become more of a concern if EMScompanies look more to debt financing than equity to fund acquisitions.

7Raymond James p. 3.8Schroder & Co. Inc. p. 3.9Thomas Hopkins and Stephen Velgot, Bear Stearns & Co. p. 4.


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INDUSTRY TERMS10

Chip-on-Board (COB) a method of affixing an unencapsulated chip onto a printedcircuit board using a wire bonding process.

Contract Manufacturing the practice of making products or sub-components ofproducts to be sold under a different companys name.

Electronic Data Interchange (EDI) the electronic transfer of data over a network.

Electronic Manufacturing Services (EMS) the industry based on providingmanufacturing services for electronics OEMs.

Original Design Manufacturer (ODM) a business model/product manufacturingmethod where a product is designed and assembly is performed upon receipt offunctional requirements for a type of product. In the typical ODM model, themanufacturer designs the complete product. In other cases, the ODM may rely on acombination of original design capabilities for some assemblies/components and off-the-shelf components and assemblies to meet the customer requirements. This allowsfor the greatest level of customization and product differentiation.

Original Equipment Manufacturer (OEM) the company behind the brandname of a product.

Pin-Through-Hole (PTH) a method of soldering electrical components to a boardsubstrate that involves pin-through-hole connections.

Printed Circuit a circuit for electronic apparatus made by depositing conductivematerial in continuous paths from terminal to terminal on an insulating surface.

Printed Circuit Board (PCB) Assembly second-level integration of active andpassive devices (electrical, electronic, optical and/or mechanical) on a rigid substrate.

Printed Circuit Board (PCB) Layout the process of transforming the electricaldesign (functional or logical representation) into a physical object (physical layout ofplacing components and routing of interconnect wires).

Surface Mount Technology a method of soldering electrical components directly

to a board substrate that uses less space than the pin-through-hold method.

Turnkey a type of outsourcing method that turns over to the subcontractor allaspects of manufacturing including material acquisition, assembly and testing. Itsopposite is consignment, where the outsourcing company provides all materialsrequired for the products and the subcontractor provides only assembly equipmentand labor.

10Industry Terms taken from Glossary section at www.solectron.com.


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D id W Sh ffi ld2000

BIBLIOGRAPHY

1. Stephen Koffler and Lori Franklin Schroeders & Co. Inc.: Initiating Coverage of

the Electronic Manufacturing Services Industry dated 12/13/99.

2. Steven Milunovich and Michael Ramirez Merrill Lynch TechStrat Picture Bookdated 3/19/01.

3. Shawn Severson Raymond James Electronics Supply Chain dated 4/17/01.

4. William Cage First Union Securities Electronics Manufacturing Services dated5/31/01.

5. Yahoo Finance Web Site: yahoo.finance.com

6. Hoovers Online Web Site: www.hoovers.com

7. Solectrons Web Site: www.solectron.com

8. Celesticas Web Site: www.celestica.com

9. MSNBCs Market Watch on 6/18/01.

10.Dain Rauscher Wessles Contract Manufacturing dated May 2000.

11.Michael Morris, Solomon Smith Barney Flextronics International: dated 6/1/01.

12.Shelby Fleck and Scott Craig, MS Dean Witter Flextronics: dated 5/7/01.

13.Michael Morris, Solomon Smith Barney Flextronics International: dated 4/25/01.

14.Jerry Labowitz and Brian White, Merrill Lynch Flextronics: dated 4/25/01.

15.Thomas Hopkins and Stephen Velgot, Bear Stearns Solectron Corp.: dated 4/9/01.

16.Shelby Fleck and Scott Craig, MS Dean Witter Solectron: dated 3/28/01.

17.Jim Savage, Thomas Weisel Partners Solectron Corp.: dated 3/20/01.

18.Todd Coupland and Helen Rattee, CIBC Equity Research Solectron: dated 3/20/01.

got capacity - ems industry by dsheffield

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