2023-07-21 10:44:40 ET
Summary
- Sanmina's annual revenue growth has recovered since the Covid-19 pandemic, but appears largely due to supply-constrained customers purchasing buffer stocks, thereby creating windfall gains for this EMS play.
- It has a superior cash position and a large stock of components, but these may become problematic in a more normalized supply-demand environment, also accentuated by a lack of visibility.
- However, there are positives due to exposure to certain industry verticals and valuations.
- It would be better to wait for the margins to be sustained before investing, and for this purpose, it is important to obtain management updates on relevant items during Q3.
A glance at Sanmina Corporation's (SANM) annual revenue growth for the last five years as charted below shows it has recovered since the Covid trough of 2020 and 2021.
Chart Built Using Data from (www.seekingalpha.com)
However, as I will elaborate later this resiliency is more a result of supply-constrained customers making purchases to ensure they have buffer stocks to shield them against potential shortages, than real demand. This situation has created windfall gains benefiting both Sanmina's revenues and profitability, which may be why Wall Street's analysts are bullish on the stock and forecasting a 27% upside.
This thesis is of a different view, given the management pointed to improvements in the supply chain during the second quarter's (Q2) earnings call on May 11. This implies a "normalization" of the demand-supply equation, and, given that the next quarter's (Q3) financial results are expected on July 28, the aim is to show it would be better to first check for progress in margins, inventories, and cash flow before investing.
I start by painting a picture of the windfall gains.
Gains Resulting from Supply Constraints
Coming back to 2020-2021, this was a period of great pain for many consumer and industrial electronics goods manufacturers globally irrespective of where they sourced goods from as due to fear of being infected, workers did not turn out at factories. In other situations, social distancing measures enforced by governments and local industries barred them from working.
Eventually, with the availability of Covid vaccines, conditions improved in most countries toward the end of 2021, with the exception of China where the authorities maintained a strict zero Covid tolerance policy signifying continued supply chain disruption for EMS (electronic manufacturing services) provider Sanmina, with its topline impacted as per the introductory chart.
In such an environment, you typically see a lot of backlog with customers also being willing to spend more money to get their hands on stocks. This helps explain the rapid increase in sales for the fiscal year 2022 as the situation started improving permitting the company to ship more products. The supply chain improvement continued in Q2 with IMS, the largest segment seeing revenues of $3.85 billion or a 29.7% YoY growth as illustrated below.
SEC Filings (seekingalpha.com)
In addition to incrementing revenues, some level of pricing power is evidenced by the gross margins progressing from 7.29% in fiscal 2019 to 7.86% last year, or an 8% gain despite revenue levels not being sustained (introductory chart), suggesting the company may have been able to increase per unit pricing, in addition to passing on costs to customers.
Now, the next question is whether such high prices can be sustained in a more normalized environment and where there could be demand uncertainty.
Unfavorable Economic Indicators and Competition
In this respect, the S&P Global US Manufacturing PMI came at a low of 46.3 in June of 2023, indicating a decline in the health of the sector. The reasons were "a sharp downturn in new orders", which points to lower demand, mainly due to high inflation and tighter monetary policy.
In addition to unfavorable economic indicators, there is also competitive positioning, as, despite focusing on the highly complex and regulated markets of the EMS industry, Sanmina faces competition, not only from potential customers now planning to be more vertically integrated emboldened by the CHIPS Act's onshoring-friendly measures but also from other peers specializing in EMS like Celestica ( CLS ) and Plexus ( PLXS ). This means that customers have a choice when selecting suppliers.
Performing a comparison of the key metrics, one can notice that while its 3-year CAGR growth is the lowest, Sanmina is in much better shape than either Celestica or Plexus when it comes to the balance sheet, namely with net debt of -$293.36 million, signifying more cash than debt.
Comparison SANM, PLXS, and CLS (seekingalpha.com)
Now, this superior cash position has allowed Sanmina to spend more capital to build large inventories as illustrated below. For this matter, having a large stock of components ready to be shipped to potential buyers is advantageous during periods of scarcity, but can become problematic during more normalized supply-demand episodes when a large inventory is synonymous with cash lying idle.
Inventory and Visibility
Going deeper, the dollar value of Sanmina's inventory went up by 100% from the January 2021 quarter to the December 2022 quarter before receding slightly to $1.55 billion in April 2023. As of May 11 during Q2's earnings call, the CFO expected further inventory improvement (or a decrease in stock level) as customers were said to be " 100% committed to those inventories".
Inventory Progression on a Quarterly Basis (seekingalpha.com)
Well, it is important to assess whether this statement is actually translating into reality during the forthcoming earnings call, as the current inventory value represented more than double the amount of cash ( $718 million ) at the end of Q2. On top, the amount of capital spent in the last quarter was $63.9 million with $60 million planned for Q3. Now, both of these numbers represent records given the historical spending trend, and while investment in future growth capacity is certainly a positive, it is important for the capital allocation strategy to be adjusted as conditions evolve in order to avoid impacting free cash flow.
Noteworthily, this could be the case if there is a reduction in the amount of cash generated from operations as customers scale down on orders or put into question the current pricing policy as more supply is available in the market. Tellingly, the levered free cash flow has receded to sub-zero during the last two quarters as shown below.
Chart Built Using Data from (www.seekingalpha.com)
Consequently, it is important to be on the watch out for inventories and capital spending in Q3 given that with an FCF margin that is well below the median for the IT sector, by around 85% , any additional investment may deteriorate the cash position itself. The issue is pressing especially for Sanmina given its relatively less visibility on demand.
This visibility problem is due to Sanmina not serving the consumer markets, but instead supplying electronics and semiconductors to manufacturers who then use them as components embedded in the final product. Thus, any change in consumer sentiment caused by high inflation, a reduction in savings, or a deterioration in the overall business climate which can in turn adversely impact purchasing behavior may only become noticeable to Sanmina when its customers slash orders, not before.
Worst, in a supply-rich situation, customers may ask for discounts and Sanmina may have to oblige given the need to get rid of its exceptionally high inventory levels. This can in turn result in lower gross margins, which on trickling down the income statement can result in an earnings miss . By the way, this was the case for the GAAP EPS during Q2.
Such a miss could spell volatility risks for the stock given its past history of producing positive quarterly earnings surprises. However, amid the uncertainty, there are two bright spots, in the form of industry exposure and valuations.
Undervalued, but Check for Sales Sustainability
With exposure to the Communications Networks and Cloud Infrastructure industry verticals for 41% of Q2's revenues (above SEC filing), potential weakness seen in the Industrial, Defense, Medical, and Automotive markets could be partially mitigated by the resiliency of IT. The underlying reason for this is IDC or International Data Corporation expects global IT spending to rise by 4.4% this year, despite being down from 2022. For this matter, Sanmina's networking and cloud business grew by 26.7% in Q3 YoY, and in view of IDC's prediction represents more real demand.
Looking at valuations, the stock scores a grade of " A " with multiples (as listed below) trading at a discount of well above 50%.
Valuation Grades (www.seekingalpha.com)
However, looking at the forward Price-to-Sales metric, the company currently trades at 20% above its five-year average of 0.32x, with this period covering both the normalized pre-Covid period and the one with windfall gains. This means that for Sanmina to continue deserving its multiple of 0.4x, it should continue to increase sales to match the corresponding 130% stock price surge during the last 5 years. This is feasible but for this to occur, the company has to sustainably increment revenues, to an estimated $9.16 billion for fiscal 2023, or a 16.11% increase over 2022. This ultimately implies it should continue to benefit from windfall gains.
However, by going through the company's revenue growth and the circumstances in which these were made possible, this thesis has shown that these windfall gains may not be sustainable due to normalization in the supply-demand equation and the deterioration of sector indicators. Here, in addition to the U.S. market which absorbed nearly 48% of its product in Q2 (SEC Filings above), the company relied on the Asia Pacific regions for 36.7% of revenues, where China's post-Covid recovery is proving to be uneven .
This said the revenue growth may not itself be impacted but the effect could be felt on profitability, in case the company has to discount unit product cost, which makes it imperative to assess the progression of gross margins for Q3. For investors, these came at 8.24% and 7.65% respectively in the last reported quarter and Q2-2022. In comparison, a more problematic scenario could crop up if customers cancel part of their orders or relinquish longer-term commitments, and, any sign of this happening would show up in the inventory numbers.
Finally, this thesis believes that the normalization of the supply-demand conditions should impact both margins and cash flow in case the capital allocation is not rectified to reflect the new normal. In these circumstances, I have a Hold position on the stock while waiting for a management update during Q3's earnings call. This should specifically cover items like product pricing, whether the inventory continues to improve, and an update on revenue guidance for the fiscal year.
For further details see:
Sanmina Earnings Preview: Windfall Gains Unlikely To Be Sustained