ENPH - Enovix: Stock Craters On Decision To Abandon U.S. Manufacturing Operations Avoid

2023-10-03 20:29:17 ET

Summary

• Shares sold off after the company decided to abandon U.S. manufacturing operations and focus on high-volume production in Malaysia next year.
• Investors shouldn't be overly surprised by the announcement as the so-called "Fab1" has been a major disaster for quite some time now.
• With the company already way behind its original business plan, Tuesday's announcement doesn't exactly instill confidence in the company's ability to ramp up its all-important operations in Malaysia next year.
• However, with first samples from the first next-generation production line in Malaysia not expected before April 2024 and a complex contract manufacturing agreement with a domestic company apparently still subject to obtaining certain official licenses and $70 million in bank financing, more delays could be in the cards.
• Enovix is likely to remain a battleground stock as bulls remain confident in the company's technology as well as T.J. Rodgers' track record while bears point to poor execution, material financing needs, and particularly the substantial risks associated with the ramp-up of the company's Malaysian manufacturing operations. For my part, I am likely to remain in the bear camp until the company has shown its ability to execute on its revised business plan.

On Tuesday, shares of advanced lithium-ion battery developer Enovix Corporation or "Enovix" ( ENVX ) sold off following the company's decision to abandon U.S. manufacturing operations and repurpose its Fremont, California plant into a " Center for Innovation " focused on new product development.

(...) This move is supportive of the Company’s strategy to locate high-volume manufacturing in Asia near customers and suppliers while locating technology development in both Silicon Valley and Asia.

Shifting Fab1’s focus will result in a reduction of the workforce in Fremont that had been dedicated to supporting 24/7 manufacturing by approximately 185 personnel, including over 125 contractors. Enovix expects this restructuring to be completed during the fourth quarter of 2023 and result in annualized savings of approximately $22 million.

(...) In addition to these actions, we have re-prioritized our activities in Fab1. We are moving from a horizontal business strategy focused on serving hundreds of customers with a standard-sized battery to a vertical business strategy focused on a smaller group of very large customers who require custom cells, which allows us the most efficient path to scale. This shift has been informed by our strong engagement with leading smartphone OEMs who we anticipate having high volume needs for our battery in 2025 and, in turn, qualification samples in the near-term.

(...) Due to this strategic shift, Enovix in the third quarter of 2023 cut off production at approximately 24,000 small cell units, less than management’s guidance of 36,000 cells. Enovix did produce enough custom cells in the third quarter, primarily for the U.S. Army program, that it expects to recognize approximately $200,000 of total revenue.

(...) Associated with the Fab1 strategic realignment, Enovix expects to take total restructuring charges of approximately $2.5 million, primarily in the third quarter of 2023, and expects to recognize accelerated depreciation expenses of approximately $36 million for Gen1 equipment between the fourth quarter of 2023 and the first quarter of 2024.

In 2024, Fab1 will shift to housing the R&D Agility Line and will be used for new technology development, materials research, process engineering, and customer sampling. Enovix also plans to add dry room space at Fab1 for battery prototyping work to support engagements with Automotive OEMs. (...)

To be perfectly honest, I wasn't exactly surprised by the announcement given the fact that Fab1 has been a major disaster for the company from the very beginning and one of the reasons for the company's largest shareholder, T.J. Rodgers' decision to step in as executive chairman last year:

We have poorly communicated on the status of Fab-1. I have heard from many investors that the delay and projected underperformance of Fab-1 must be the result of some catastrophic technology problem. For the record: Fab-1 is going to work and ship a lot of batteries to our customers ? period . I will personally be in all Fab-1 reviews, because Fab-1 is not only critical to the Company, but also to our customers, some of whom are designing products right now that could not exist without Enovix battery performance.

Subsequently, he replaced basically the entire senior management team with seasoned executives from Micron ( MU ) and Western Digital Corporation ( WDC ) in an attempt to " infuse Enovix with a silicon-industry mindset " as stated at the beginning of his " Special Presentation to Shareholders " released in early January.

At that point, the company was already way behind its original business plan and Tuesday's announcement didn't exactly instill confidence in the company's ability to ramp up its all-important Fab 2 operations in Malaysia next year.

Mr. Rodgers again discussed the issues regarding Fab1 in an attempt to stave off a suspected " hit piece " in July:

As you know, we failed in our first fabrication plant (Fab1) in Fremont, California to produce our planned number of batteries (...).

The automation (...) in our equipment was non-functional on day one and remains non-functional today due to the China COVID lockdown that prevented the equipment manufacturer from ever installing or even servicing its line in Fremont.

We did our best with local consultants and Chinese-language manuals and got all the battery-making tools to work manually.

So, our stated plan to ramp up Fremont production on two autolines, each designed to produce 550 units per hour (uph), turned into a reality of ramping one manual line, currently running at 100 uph, equating to 9% of our planned capacity.

The batteries we make are fine, but the economics are not, as we have 160 unplanned workers on four shifts hand-carrying the batteries from machine to machine.

We are now well along on the process of turning Enovix around from its Fab1 misadventure, consistent with the January 3rd shareholder report.

Solving the problems we encountered on the first line led us to our design for the Gen2 autoline, which will operate at 1,350 uph and is nearing completion now, as CEO Raj Talluri reported during his personal inspection of autoline testing in the factory of our new autoline manufacturer. (...)

To be perfectly clear, I don't have any issues with new management pulling the plug on the Fab1 " misadventure ", but the company's apparent inability to fix the problems is likely to result in market participants once again scrutinizing Enovix's ability to manufacture its products in a commercially viable manner, very similar to the institutional shareholder concerns revealed in the " Special Presentation to Shareholders " in January:

While many investors are crediting Mr. Rodgers with the impressive turnaround at microinverter manufacturer Enphase Energy ( ENPH ) in recent years, Enovix is a very different story as T.J. Rodgers has been involved in the company for more than a decade already and even engineered the 2021 backdoor listing by merging the company into a SPAC established by him.

Personally, I would like to see him spending less time defending Enovix against perceived short-seller attacks and lengthy presentations with frequent referrals to the 1985 boxer drama film "Rocky IV" and solely focus on near-term execution as arguably the best means to address market participants' concerns.

However, close followers of the company shouldn't be surprised by Tuesday's announcement after new management already hinted at potential changes in the questions-and-answers session of the most recent conference call :

Chris Souther

(...) Maybe on the production from Fab-1 came in ahead of the target in the second quarter targeting 36,000 in the third quarter. Are we still targeting 180,000 for the full-year or does the acceleration of some of the larger laptop phone batteries change that target? Just are there any specific things you'd call out we would need over the next few months to hit 180,000 if that's what we're still looking for? And is there any significant expectation from the agility line this year?

Raj Talluri

Yes, great question. We absolutely with the way the manufacturing is going on Ajay and his team have done a phenomenal job. We can make those 180,000 batteries as you know, if we -- if you wanted to at this point absolutely, that's the goal. But now that we have these opportunities for higher value from both these larger cells for the army and for laptops and other areas, and as the question was asked, what do we do about the EV stuff.

We are getting a few other ones and we only have one fab here. The agility line is coming. So based on how quickly the agility line comes in and how to optimize the ones, the fab here we are going to update you on exactly what we want to do for the rest of the year. But it's a good mix problem we have that we have more opportunities to work on, and we have to make sure we want to build the right ones.

With the U.S. manufacturing operations being abandoned, the company's fate will solely depend on its ability to ramp up large-scale operations in Malaysia in a manner sufficient " to graduate from producing thousands of units to millions of units in 2024 " as projected by the company's COO in Tuesday's press release.

However, with first samples from the first next-generation production line in Malaysia not expected before April 2024 and a complex contract manufacturing agreement with a domestic company apparently still subject to obtaining certain official licenses and $70 million in bank financing, more delays could be in the cards.

On July 26, 2023, Enovix Corporation (...) entered into a manufacturing agreement with YBS International Berhad (...). Under the direction of Enovix and using Enovix proprietary technology, YBS will manufacture and Enovix will purchase batteries in accordance with Enovix specifications. The initial term of the Agreement is ten years and will automatically renew for one successive five-year period unless earlier terminated. (...)

Enovix and YBS have agreed to share the initial investment of $100 million United States dollars for the equipment for the Gen2 Line 1 and facilitation costs, as set out in the Agreement.

Enovix will contribute 30% and YBS has the obligation to finance the remainder 70%. YBS will obtain $70 million in financing for manufacturing operations under the Agreement from OCBC Bank (Malaysia) Berhad (“OCBC”). Enovix is in discussions with OCBC to provide collateral for YBS’ financing arrangement. Pricing under the Agreement is set on a cost-plus basis and is subject to a minimum commitment on behalf of Enovix. At any time during the first seven years of the Agreement’s term, Enovix reserves the right to purchase the Gen2 Line 1 by repaying the YBS financed amount set out in the Agreement net of depreciation and Enovix shall also bear the early repayment penalty fee imposed by the financier (if any).

Please note that YBS is a rather small company with a $32.6 million market capitalization and annual revenues of below $20 million in the last fiscal year. In addition, the company's contract manufacturing operations appear to be tiny:

Moreover, securing $70 million in bank financing would result in the company's debt to increase by almost 500%.

Given the size and financial condition of YBS, it is hardly a surprise that Enovix will be required to provide substantial collateral to the bank.

According to the terms of the agreement filed by YBS with the Malaysian stock exchange, it will be solely up to Enovix to get the facility ready for production (emphasis added by author):

The Parties have agreed to share the initial investment of United States Dollars ("USD") One Hundred Million (USD$100,000,000) for the machinery and facilitisation costs whereby Enovix will contribute thirty (30%) percent and YBS has the obligation to finance the remainder seventy percent (70%). Enovix shall ensure that the facilities funded by the 30% Contribution to be ready within 6 months from the date of this Agreement .

In addition, the agreement is conditional upon YBS obtaining the " relevant licences from the relevant authorities to manufacture the products within six months from the date of the agreement or such other extended period as may be agreed by both parties. "

At least in my opinion, there's a lot to dislike about this agreement:

• the agreement remains conditional upon YBS obtaining significant bank financing and official licenses
• YBS has no experience in lithium-ion battery manufacturing
• YBS's financial condition will likely require Enovix to provide substantial cash collateral for the required $70 million loan thus negating most of the capex savings advertised by new management
• given the aforementioned uncertainties, the timeline looks aggressive

So why did Enovix's new management come up with this less-than-stellar transaction? My best guess would be the requirement to lower cash burn and pressure of time as designing, constructing, and equipping a new facility from scratch would have required considerably more time and investment.

Quite frankly, I can't say that I am impressed by the new management's approach to establishing the company's all-important Malaysian manufacturing operations but the company apparently lacks the time and funds to take a step back and find a more suitable partner or even go it alone.

Lastly, I was surprised by the company's recent decision to acquire its Korean supplier of coated electrode rolls, Routejade, for approximately $100 million in cash and stock based on the value of Enovix's common shares at the time of the announcement.

While management touted a number of benefits, the vertical integration move will lock Enovix into Routejade's solutions for the time being.

Bottom Line

While Enovix's decision to abandon its just recently established U.S. manufacturing operations shouldn't be considered a major surprise, Tuesday's announcement is likely to result in market participants increasingly scrutinizing the company's ability to ramp up its all-important Malaysian manufacturing operations in a timely manner.

At least when judging by the experience and financial condition of the company's selected contract manufacturer as well as the terms of the manufacturing agreement, concerns appear to be well-founded.

Personally, I wouldn't be surprised to see production in Malaysia being delayed further or even scrapped entirely due to financing and/or licensing issues.

In the meantime, Enovix is likely to remain a battleground stock as bulls remain confident in the company's technology as well as T.J. Rodgers' track record while bears point to poor execution, material financing needs, and particularly the substantial risks associated with the ramp-up of the company's Malaysian manufacturing operations.

For my part, I am likely to remain in the bear camp until the company has shown its ability to execute its revised business plan.

Risk Factors

Supportive analyst commentary and particularly additional insider buying by T.J. Rodgers and members of the company's new management would be suited to provide a short-term catalyst for the heavily-shorted stock but ultimately all will depend on the company's ability to ramp operations in Malaysia next year.

Should Enovix indeed master the above-discussed challenges, shares are likely to rally big time.

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