ENVX - Enovix: Overreaction To Strategic Realignment Of Fab1 Plant

2023-10-10 11:40:23 ET

Summary

• Enovix Corporation announced the strategic realignment of its Fab1 facility, which was never meant for high-volume production, to focus on product development.
• Also, the company announced that Fab1 will now focus on a few very large customers who require custom cells rather than hundreds of small customers.
• This is positive because it comes from engagements with leading smartphone OEMs that are expected to have high-volume needs in 2025 and thus have urgent qualification needs.
• Also, this leads to a more efficient path for Enovix to scale up by focusing on a few very large customers with high-volume demands.
• In my opinion, the focus here should not be on Fab1, but rather, should be on the ramp-up of Gen2 ramp in its Fab2 facility.

Enovix Corporation ( ENVX ) has announced a strategic realignment of its Fab1 facility.

The negative share price reaction was a surprise for me, because I think that this news was actually expected, in-line with prior management comments and a positive for the acceleration of product development.

In fact, the focus of investors should not be Fab1, but rather, the key for me will be Gen2 ramp up in Fab2. The successful ramp of its Gen2 autoline in Fab2 will be key to driving the long-term value of the business, and this is what I am focusing on right now.

In my view, buying on weakness here makes sense because I believe that the Gen2 autoline is on track for factory acceptance testing in the second half of 2023, and installation in first half of 2024 in Fab2 in Malaysia, ahead of high-volume production starting in the second half of 2024.

It does seem that the market tantrum on the strategic realignment of the Fab1 facility is overdone given that management has already made prior comments that Fab1 will not be focused on high-volume manufacturing and thus, focused more on product development instead.

What happened?

Fab1 to focus on product development

Enovix announced the strategic realignment relating to Fab1.

Both of these are strategic decisions that help set up the long-term success of the company.

First, the company made the strategic decision to refocus Fab1 in Fremont to become the "Centre for Innovation" for the company.

For those of you who are new to the Enovix story, Fab1 is not meant for high-volume manufacturing, but it serves qualification needs, is meant to demonstrate manufacturing improvement, and it is gradually moving towards one focused on product development.

Fab2, which is in Malaysia, is the facility meant for high-volume manufacturing.

This is expected to lead to a restructuring for Fab1 given the shift in focus towards new product development. As Fab1 was previously dedicated to manufacturing 24/7 with 185 personnel, Enovix will be reducing the workforce in Fab1. This restructuring will be completed in the fourth quarter and resulted in $22 million in annualized savings.

Commentary

Firstly, as highlighted before, management has made prior comments that Fab1 will be focused on product development rather than high volume manufacturing. As such, the news about the focus of Fab1 for product development is not new.

Secondly, I have seen many articles that highlight that Fab1 is the " manufacturing hub " of Enovix or that Enovix is " abandoning US manufacturing operations". These articles are just simply not true because if you know Enovix, you will know that Enovix's Fab1 is not where the high-volume manufacturing will be. That is what Fab2 is for.

Thirdly, if you look at the full picture, with Enovix's strategy to locate their high-volume manufacturing in Asia, it makes sense for Fab1 in Fremont to be focused on new product development.

Enovix located its Fab2 facility in Asia, where it can be near to customers and suppliers, while Fab1, being in Fremont, would be more suitable for technology development.

Fourthly, the reduction of workforce seems logical here, because Fab1's production process was more manual, requiring more personnel. Out of the 185 personnel supporting the operations in Fab1, more than 67% of those are contractors, which will no longer be useful for Fab2.

So the question now is will these personnel not be needed in Fab2?

Enovix has hired a strong team for Fab2 in Malaysia and in fact, that team has already been down to Fab1, undergone the training on the equipment in Fremont in Fab1. As such, any learnings would also have been transferred to the team in Fab2 for the purpose of high-volume manufacturing.

Fab1 to focus on larger customers

Secondly, Enovix made another strategic decision for its priorities for Fab1.

The company has been focused on a horizontal business strategy, where it was spread out across hundreds of customers with a standard sized battery.

Instead, Enovix will move towards a vertical business strategy. This means that Enovix will now be focused on a smaller group of very large customers who require custom cells.

The strategic decision to change its strategy for Fab1 is due to management's engagement with the leading smartphone OEMs. Enovix expects that these leading smartphone OEMs have high volume needs for Enovix in 2025 and thus, will require the necessary qualification samples in the near-term.

On top of that, with the high volume needs of these leading smartphone OEMs, this will enable Enovix to have a more efficient path for it to scale its business up.

According to CEO Raj Talluri:

Because of this immediate need and the additional resources required to make custom batteries for the U.S. Army, I directed our teams during the third quarter to reduce production of our small, standard-sized IoT and Wearable cells out of Fab1 and change over the tooling to make batteries for these larger custom cell customers.

As a result of this strategic shift, Enovix cut off the production of small cell units at about 24,000 units, less than the guidance of 36,000 units. This was done in order to produce enough custom cells in the third quarter for the US Army program, which will generate $200,000 in revenues this year.

Commentary

The strategic decision to change its strategy for Fab1 is due to management's engagement with the leading smartphone OEMs. Enovix expects that these leading smartphone OEMs have high volume needs for Enovix in 2025 and thus, will require the necessary qualification samples in the near-term.

Firstly, I think that this change in focus is a positive dynamic because we are seeing some visibility in some large customers, specifically, leading smartphone OEMs.

The urgency here does hint that Enovix expects the near-term customer demand to come largely from smartphone OEM customers. This, in my view, is positive because of the large volumes that Enovix will obtain since these are likely very large smartphone OEMs.

Secondly, Enovix is at a stage where it should prioritize large customers to secure large volumes so that we see better economics in the near-term. The decision here to focus on the urgent need for qualification samples by these leading smartphone OEMs is the right one, in my view, because the team is acting decisively to ensure it can meet the qualification demands of these large customers.

Why sell smaller cells to hundreds of customers when you can sell larger custom cells to a few large customers?

Fab1's purpose

I mentioned that Fab1 has served its purpose earlier. What are they?

There are two primary purposes that Fab1 serve.

The first is to meet its manufacturing improvement goals in terms of yields and output.

In the past few quarters, we have seen the team exceed their manufacturing improvement goals, doubling output from Fab1 each quarter.

While the cell production was cut off at 24,000 cells in the third quarter, this was done so to deliver enough custom cells for the US Army contract.

Because Enovix has already seen significant yield improvements in Fab1, I do think that Fab1 has served Enovix well in this regard.

The second purpose here was to produce enough cells for customer qualification demand and to support customer product launches until Fab2 starts running in 2024.

Again, here Fab1 has served its purpose as it has met qualification demand, whether in small cells or custom cells, and Fab1 is currently serving the demand needed for the US Army contract.

With the strategic realignment of Fab1, Enovix expects to recognize accelerated depreciation expenses on Gen1 equipment for 4Q23 and 1Q24, and expects restructuring charges of about $2.5 million, primarily in 3Q23.

Starting in 2024, Fab1 will then house the R&D Agility Line and it will be used for development of new products and technology, materials research, process engineering and customer sample.

In addition, Enovix also will be adding a dry room space in Fab1 for battery prototyping work to support its engagements with automotive OEMs.

Fab2 ramp up will be key

To be honest, Fab1 was never going to move the needle for Enovix, so the price reaction for this news is definitely surprising.

The big picture here is Fab2.

Enovix COO Ajay Marathe said that his operations team has been working hard to test and qualify the Gen2 equipment to be used in Fab2 in order to move from producing thousands of units to millions of units in 2024.

I will be keeping my eyes on the progress on factory acceptance testing in the second half of 2023, and installation in first half of 2024 in Fab2 in Malaysia, and finally, high-volume production starting in the second half of 2024.

This will be the key to turning around confidence in Enovix, and Fab2 will be the key driver of Enovix's long-term financials.

What are other investors saying about this strategic realignment?

I spoke to both JPMorgan and TD Cowen, both of which have been covering Enovix for almost as long as I have.

For JPMorgan, the view here is that the strategic realignment of Fab1 makes strategic sense to them and it should result in an acceleration of product development, including in the area of EVs.

The analyst actually said he thinks "investors are losing sight of the big picture." And I do agree with this as well.

For TD Cowen, the view is that it was not surprising to them that this strategic decision was made. In particular, the analyst cited evidence that the management had already previously noted that the company is "likely to focus on higher value opportunities for larger cells, including that of the US Army.

Concluding thoughts

One final point I will note here is that the weakness in share price is likely a result of a loss in confidence in the management seemingly changing their strategy again after the special presentation was made by T.J. Rodgers earlier in the year.

This strategic change was also done before the end of the year. Recall that Enovix had the target to double shipments every quarter in 2023. While this would have been achieved in the third quarter if not for the US Army contract, if Enovix managed to demonstrate its ability to double shipments until the end of the year, this may have been better for investor confidence.

Yet, Enovix needs to be able to show that it can meet customer demand, so it needs to use Fab1 to deliver the custom cells needed by the US Army.

At the end of the day, I am comfortable with the yield and output improvements we have seen thus far for the third quarter of 2023, and we are just one final quarter short of meeting this goal of doubling shipments each quarter in 2023.

I would rather Enovix meet the qualification demands of its large customers, which may then lead to customer wins, than have Enovix meet this final quarter of doubling goal.

As long as Enovix feels like it has already met its manufacturing improvement goals for what is necessary for Fab2, I think that the decision to focus on large customers is the right one here for the long-term of the company.

The focus here should be on the ramp of Fab2, and in my view, the strategic shift at Fab1 supports this. This increases the likelihood of a high-volume customer and thus, lead to a more efficient path for Enovix to scale.

Last but not least, one member of Outperforming the Market reminded the community one very important thing, which I agree on and share here as well: Enovix is a volatile stock, given that the company is not yet at high-volume manufacturing phase. It is important to keep in mind that if you decide to enter a position in Enovix, the position sizing should be small to reflect this risk.

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