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EMS companies still plagued by pricing pressures

Aug 26, 2003

Pricing Pressure Still Weighing On EMS Sector

By Stuart Weinberg

Of DOW JONES NEWSWIRES

TORONTO (DOW JONES)--Despite massive restructuring efforts, pricing pressure continues to plague the electronics-manufacturing-services sector, putting pressure on profits of top-tier EMS companies like Celestica Inc. (CLS), Flextronics International Ltd. (FLEX) and Sanmina-SCI Corp. (SANM).

"The confluence of weak demand (carriers, corporations and consumers continue to defer purchases of electronic goods) continue to result in a deflationary pricing environment for finished products," Deutsche Bank Securities analyst Chris Whitmore said in a research note Monday.

EMS companies build the servers, computer hardware and telecom gear used by some of the world's biggest original equipment manufacturers, such as International Business Machines Corp. (IBM), Cisco Systems Inc. (CSCO) and Hewlett-Packard Co. (HPQ).

In recent weeks, as EMS companies and their OEM customers released financial results, it was clear that the tech-spending drought continues. Last week, Celestica, Toronto, reported a second-quarter adjusted loss of 7 cents a share, below the Thomson First Call mean estimate for a 4-cent loss. It was the first adjusted loss in the company's history.

Flextronics, headquartered in Singapore but operated from San Jose, reported a first-quarter pro forma profit of 4 cents a share on July 24, a penny short of the Thomson First Call mean. "Flextronics suggested that the pricing environment remains difficult, implicitly suggesting that its optimism in stabilizing prices has waned," Whitmore said.

Several OEMs in the PC/IT hardware industry, including Sun Microsystems Inc. (SUNW), EMC Corp. (EMC), Apple Computer Inc. (AAPL), Lexmark International Inc. (LXK) and Xerox Corp. (XRX), suggested during earnings conference calls that the pricing environment remains very aggressive, Whitmore said. Sun, a top-three Celestica customer, made it clear it plans to stay very cost competitive in the second half of 2003, he said.

Aggressive pricing is also evident in the handset industry, Whitmore added. For instance, third-quarter handset margins at Nokia Corp. (NOK) disappointed the Street, while average selling prices of Siemens AG (SI) handsets fell 7.5% in the second quarter compared to the first quarter, he said.

New Business Not Enough To Offset Pricing Pressure

While pressure on OEMs to cut costs is leading to more outsourcing, new business isn't enough to offset the pricing pressure. EMS-sector margins are down 500 basis points since 2000 and it might take a while to get that back, Whitmore said. "We believe (the second quarter of 2003) will be the low-water mark...but are wary that it will be a long road back to respectable margins," he said.

Not surprisingly, Whitmore's earnings estimates are conservative, about 30% below mean estimates. For example, he sees Celestica posting adjusted net of 25 cents a share in 2004, compared to the mean estimate of 41 cents. He sees Flextronics posting adjusted net of 35 cents in fiscal 2005 compared to the mean estimate of 50 cents. Flextronics has a March 31 fiscal year-end.

Whitmore's revenue forecasts are only about 5% below the Street. For Celestica, he sees revenue of $6.7 billion in 2004 compared to the mean estimate of $7.2 billion. For Flextronics, he sees revenue of $13.9 billion next year compared to the mean 2005 estimate of $14.8 billion.

One thing that will inevitably occur is consolidation, Whitmore said. Margins are unsustainably low and consolidation will help shore up profitability by eliminating extra capacity, he said. "We estimate the EMS industry's capacity utilization is less than 50% and that there are over 10 contract manufacturers/ODMs (original design manufacturers) with annual sales of at least $2 billion," he said in a June 30 research note. "As a result, returns across the EMS/ODM industry have plummeted...and are at unsustainable levels."

-Stuart Weinberg, Dow Jones Newswires

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