Understanding the electronic manufacturing services industry

In the rapidly evolving world of technology, the electronic manufacturing services (EMS) industry stands out as a dynamic sector in the global market. Not only have several companies within this industry recently been listed, but they have also performed well. Evidently, the buzz around this industry primarily stems from its growth potential.

As per Frost & Sullivan, the Indian EMS industry is expected to grow at an annual rate of 34 per cent until FY26, reaching a staggering value of Rs 4.5 lakh crore. This growth is attributed to the ongoing 'China plus one' trend, where companies (mostly in developed countries) are seeking to diversify their supply chains and moving away from a sole dependence on China.

In a bid to boost this growth further, the Indian government has introduced the PLI (production-linked incentive) scheme, which will attract investments as well as offer incentives to manufacturers.

So, we chose to dive deep and see how the companies in this industry operate and the factors to look at while analysing such companies.

Understanding EMS: Operations and categories

Companies in this industry operate as contract manufacturers for global consumer brands. Initially, these companies focused solely on segments like manufacturing and assembling products. However, over the last few years, they have expanded operations into the designing of products. The operations of these companies can be classified into four main categories:

• Original design manufacturing : Companies (original design manufacturers or ODMs) manufacture products as per the specifications provided by the original equipment manufacturers (OEMs).
  
• Electronics manufacturing services: It is the most prevalent model in India , where companies manufacture products based on customers' specifications.
  
• Job work: Companies are only responsible for assembling the products. Very small-sized companies follow this model.
  
• After-sales services: Companies are responsible for maintaining their customer's brand identity in the market.

In India, the typical services offered by the companies in this industry include printed circuit board (PCB) assembly, box builds of electronics (manufacturing the final product, including adding the OEM's logo and dispatching to the warehouse for selling) and contract manufacturing of consumer electronics.

Let's have a look at the most common features of the companies within this industry.

Key features of EMS companies

• Client relationships and revenue concentration: Companies in this industry usually have a limited client base due to the high scale of manufacturing and quality standards. Therefore, maintaining strong relationships with them is essential for future growth. Customer retention ratio and the duration of client associations are key indicators of strong client relationships.
  
  For instance, Cyient DLM 's prominent customers have been associated with it for over 11 years, as of FY23.
  
  However, a limited client base may lead to concentrated revenue sources. This means that a few customers contribute to the majority of the revenues. This is very common in an industry like this, and due to this, their trade receivables are also high. For instance, the top five customers of Cyient DLM contributed to more than 65 per cent of the revenues in FY23. The loss of any significant client can substantially impact the company.

Revenue concentration

DCX Systems' largest customer accounted for about 56 per cent of revenue in FY22

Company	Revenue from top five customers (FY22)	Revenue from top five customers (FY22)	Trade receivables as a % of revenue (FY23)
Avalon Technologies	49.7	64.6	17.5
Cyient DML	65.4	93.2	14.6
DCX Systems	80.6*	99.7	26.2
Elin Electronics	63.2	77.1	26.9
Kaynes Technologies	37.2	51	16
*Top three customers. FY22 numbers are taken from IPO prospectus.

• Low margins and pricing pressure: Companies in this industry usually operate at low margins. This is because they do contract manufacturing for consumer brands. As a result, there is a lack of bargaining power. However, it also depends on the kind of services the companies provide. If a company operates as an ODM, margins are relatively high as they offer end-to-end solutions to the clients. However, because the majority of companies in India are EMS, they witness pricing pressure, which impacts margins.
  
  However, low margins do not translate into a bad business. While high margins are desirable, one must also look at the asset turnover (sales generated per unit of assets) and financial leverage (leverage results from using borrowed capital, trade payables, etc., to generate returns) when looking at the companies.
  
  Take EMS giant Dixon Tech , for example. The company, which primarily generates revenue through the manufacturing of mobile phones, has a three-year average net profit margin of just 2.1 per cent. However, its asset turnover and financial leverage stood at 2.9 and 3.9 times, respectively. As a result, the company reports a robust ROE of 23 per cent.

DuPont ROE: Three-year average (FY21-23)

Even with low margins, the majority of the companies have high ROE due to high financial leverage

Company	Net profit margin (%)	Asset turnover (times)	Financial leverage (times)	Return on equity (%)
DCX Systems	5.4	1.1	12.3	64.4
Avalon Technologies	5.6	1.4	6.2	50.3
Cyient DLM	3.7	1.0	12.9	43.2
Dixon Technologies	2.1	2.9	3.9	23.1
Kaynes Technology	5.6	1.2	2.7	16.3
Syrma SGS Technology	5.9	1.1	2.2	13.9
Elin Electronics	3.4	1.9	1.8	11.8
Amber Enterprises	2.6	1.1	2.7	7.3
Asset turnover is calculated as sales divided by average total assets. Financial leverage is calculated as average total assets divided by average equity.

• Dependence on client's business: Customers generally recall the product by the brand that is selling it (client of EMS companies) and not by the manufacturer's name. As a result, these companies' businesses generally depend on the factors influencing the client's business, such as reputation and demand.
  
  For example, if the demand for Xiaomi phones starts declining, it will impact Dixon Technologies' operations as it manufactures phones for them.

Conclusion

When considering companies in the EMS sector, it's crucial to evaluate the kind of services provided by companies and the quality of their clients. Additionally, the industry's dependency on China for raw materials remains a concern.

While the EMS industry is on a solid growth trajectory, not all companies may qualify as good investments. Therefore, readers are advised to do their due diligence before investing. Understanding the fundamental dynamics of the EMS industry is key to making informed investment decisions.

Also read: Read this before investing in a cement company