EMS Providers Just Can’t Stop the Cost-Cutting

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Contract manufacturers may be able to one day put away their cost-cutting scalpel but that won’t be for a while going by events in the market today. In the electronics manufacturing services (EMS) sector, cost-cutting and never-ending rounds of corporate reorganizations have become a way of life as customers and their contractors engage in a constant struggle to increase revenue, fend off profit erosions and improve operating margins.

In this sector of the electronics industry alliances and contracts have very short shelf lives, change is constant, margins are wafer thin or severely depressed and failure to respond swiftly to slumping demand can jeopardize not just market share but even the health of the enterprise. The situation is compounded by severe pressure from OEMs that are constantly demanding better pricing concessions from EMS providers to stay competitive.

The pressure is intense for all players in the EMS market. Top players like Foxconn Inc., Flextronics International Ltd. and Jabil Circuit Inc. may be reporting revenue growth but they are as challenged as small to medium-tier rivals in efforts to retain long-term OEM contracts, increase margins and prove to stockholders that share price appreciation is possible for the publicly-traded companies serving the sector.

Recent developments at Plexus Corp. show why the market is in constant flux. The Neenah, Wis.-based EMS provider isn’t completely over the hump yet but it appears to be steadily recovering from last year’s crippling loss of a major OEM contract that analysts initially said could severely hamper its revenue and profit growth.

Juniper Networks accounted for approximately 16 percent of Plexus’ annual revenue when the networking equipment vendor last November shocked its EMS partner by abruptly cancelling the contract. In response, Plexus embarked upon a round of cost-reduction activities coupled with aggressive actions to beef up sales by expanding and building on contracts in other industry segments.

The latest quarterly results indicate how far Plexus has come in recovering from the Juniper loss. The company reported revenue of $572 million for the fiscal third quarter ended June 29, down 6 percent, from $609 million in the comparable year ago period. The cost reductions helped to boost gross profit margins, though, to 9.7 percent in the 2013 fiscal third quarter from 9.4 percent in the fiscal 2012 fiscal third quarter.

“Gross margin was positively impacted by operating performance initiatives, customer mix and good performance from the engineering solutions organization,” said Ginger Jones, Plexus’ CFO during a presentation to analysts on July 18. “In addition, margins in the fiscal fourth quarter will benefit from a lower level of expected revenue with Juniper. This customer is dilutive to margin and we will continue to see the impact of the disengagement on margins in the fiscal fourth quarter.”

It could have turned out differently. The disengagement with Juniper was not only unexpected and sudden but it also occurred at a time of uncertainty in some of Plexus’ end markets. Sales signals from the industry are mixed, according to president and CEO Dean Foate, and the reduced visibility may continue for a while longer. Losing a long-term customer in such an environment was disheartening to Plexus executives and the company continues to struggle with efforts to plug the gaping hole.

Cancelled Contracts, Cancelled Dreams

The actions taken by Plexus after Jupiter terminated their relationship are exactly the ones any leading enterprise reorganization expert would suggest. It is going after new businesses, especially in more recession resilient market segments, including medical equipment and what it describes as “life sciences”, defense, security and industrial. The company is also improving operations by consolidating manufacturing in more cost-competitive locations like Romania and it has reduced overhead in certain segments.

“We have completed the move into our new facility in Oradea, Romania, with no disruptions to our customers,” Foate said during the fiscal third quarter conference call. “We now have a significant presence and capability in lower-cost Europe to drive growth. We completed the move into our new manufacturing and design center facility in Livingston, Scotland, providing a stronger product realization for our customers in U.K.”

The payoff from these activities should help the company eventually overcome the negative effects of losing the Jupiter contract. Right now, though, Plexus is still hurting because of the double-whammy that comes from its dependent upon a handful of customers. Each time sales to any of these customers contract, Plexus feels the pinch strongly. Staying buoyant in its industry segment will require even greater diversification and further actions to reduce Plexus’ reliance on its top customers.

It’s a problem other mid-tier contract manufacturers grapple with constantly. As customers shift alliances depending upon their own changing needs, EMS providers are reminded they can lose manufacturing contracts anytime even if they’ve engaged with the specific customer for a long time –more than a decade in the case of Jupiter and Plexus. Often, too, they get limited notice about the termination of such engagements.

Plexus could take lessons from bigger competitors that have been burrowing deeper into the supply chain to strengthen sales and profit margins. Jabil, for example, has more than $4 billion in quarterly revenue but wants to increase this with acquisitions that complement an already extensive range of services.

The latest of such deals is Jabil’s $665 million purchase of healthcare, packaging and consumer electronics vendor Nypro Inc. The transaction, which closed on July 1, was aimed at shielding Jabil from uncertainties in certain segments while increasing the competitiveness of its offerings in the healthcare sector.

“The combined entity of Jabil and Nypro is expected to bolster their position in key markets, such as healthcare and expand the market in packaging for customers in the food and beverage, household and personal care industries,” Jabil said in a statement announcing the closing of the deal.

Transactions like this not only help companies reduce the impact of negative developments – such as an abrupt and unanticipated termination of a contract with an OEM – they are also useful in balancing out variations in sector performance. Though, most of the leading contract manufacturers try to spread out the inherent risks in their operations by serving many market segments it’s still not unusual for wide swings to occur on a quarterly basis in sales as Jabil discovered in its latest reporting period.

During Jabil’s fiscal third quarter ended May 31, for example, sales fell 4 percent in the diversified manufacturing division, rose 4 percent in enterprise and infrastructure and jumped 23 percent in the high velocity division. Total revenue increase for the fiscal reporting period was 5 percent, according to Forbes Alexander, Jabil’s CFO.

With sales varying so widely in the company’s key reporting segments, Jabil too is embarking upon another round of reorganization, executives said without disclosing details although these will inevitably include plant closures and layoffs. Forbes said the reorganization will result in $188 million in charges. Savings from these actions will be between $30 million and $40 million in Jabil’s fiscal 2014 and increase to an estimated $65 million in fiscal 2015, Alexander said.

“We are constantly evolving our resources, our assets and our capacity as our business grows and needs change,” said Mark Mondello, Jabil’s CEO. “It's been 7 years since we have formally reset our structural costs. [Since then,] we've added $8 billion in revenue, 100,000 employees and 10 million sq. ft. of manufacturing capacity. Over the next 12 to 18 months, we will optimize our foundation in anticipation of the business ahead. This is a prudent decision tactically, strategically and financially.”

That’s just the nature of the business.