Nordic contract manufacturers have maintained their efficiency over years of growth

Translation: Original comment published in Finnish on 9/8/2023 at 9:29 am EEST

We have examined longer-term ROIC, components of return levels and underlying explanatory factors of Incap, Scanfil and four other Nordic electronics industry contract manufacturers. Overall, the companies’ return on capital has been at an excellent level and strengthened during our review period. Together with strong growth, high returns on capital have brought excellent returns to owners during our review period. We examined the companies’ growth and acquisitions earlier here.

Return on capital has exceeded the cost of capital

We consider ROIC to be the best individual indicator of company-specific quality for two reasons: 1) the basic prerequisite for long-term sustainable value creation is that the underlying business is able to generate more than the cost of the capital it ties up (ROIC > WACC), and 2) ROIC is based purely on operational performance and does not include the effects of different capital structures (cf. ROE).

From Incap’s and Scanfil’s competitive field we have chosen Norwegian Kitron and Swedish Note, Inission and Hanza as peers. The selected companies are positioned mainly in industrial electronics with higher profitability potential than consumer electronics, where the technical requirements of the manufactured applications or their parts are high and the production series are small (high mix/low volume). On the other hand, on average the smaller companies in industrial electronics typically commit more working capital than large companies focused on consumer electronics, which means that neither segment can be automatically labeled as better than the other, despite margin differences. For smaller companies, however, the high mix/low volume position sought by Nordic players is very natural.

In our review, we have looked at ROIC through adjusted EBIT and operational invested capital (intangible operational assets + fixed operational assets + net working capital). We find this approach justified as it gives a correct picture of the capital required by the actual business (incl. acquisitions). After Inission as the last of the bunch switched to IFRS reporting, the comparability of key figures for recent years also improved.

Profitability has improved, but capital turnover has slowed down

ROIC can be divided into two main components: operational efficiency, i.e. the performance of the business, and efficiency of capital use, i.e. the ability to get the most out of the available assets. In line with these two components, we believe ROIC is best understood as the operating profitability multiplied by the rate of return on invested capital We have dismantled the companies’ ROIC into their components in the following tables.

When examining operational efficiency, we note that the companies’ EBIT margins have strengthened over time. We believe this is explained by the strong demand picture supported by the increased outsourcing rate and the growth in the end market for products, to which the total supply reacts with a slight delay. We also estimate that the increased size class has brought some economies of scale in procurement and pricing power for the companies.

Company-specifically Incap’s margin level has been significantly higher than that of other manufacturers. The significance of the observed profitability difference is, in our opinion, further emphasized by the fact that the operating margins of other Nordic players are also on good levels considering the entire industry. The explaining factor behind Incap’s profitability advantage is not a deviating product mix or relative pricing power, as historically, the company’s sales margin has been about 6 percentage points lower than for other manufacturers reporting based on cost category. Thus, we believe that the root causes of the higher margin level stem from an efficient operating model where overheads and other operating expenses have been pushed to a lower level than competitors, especially thanks to the company’s light administration structure and India’s highly cost competitive production plant (incl. low personnel costs). However, in H2’23, Incap’s rocket-like growth will slow down due to the partial realization of the risk created by the company’s concentrated customer structure, which resulted in the company issuing a profit warning in the spring. At the same time, the company’s margin level and ROIC will decrease from the level seen lately.

The other extreme of the group is Hanza, whose sales margin has been about 10 percentage points higher than for the rest of the group, while return on capital has been below the group’s average. The high sales margin and other operating costs are primarily explained by Hanza’s slightly deviating strategy, in which the advisory business plays a larger role than for its competitors. Due to the differences in business structures and product mixes, a straightforward comparison of the sales margin does not necessarily lead to the right conclusions, so we feel EBIT-% (or adjusted EBIT-%) are the primary indicators of profitability.

Similarly, as regards the efficiency of capital use, we note that the capital turnover of all companies is high but on a slight downward trend. We estimate that the lower capital turnover in the industry reflects the component supply difficulties caused by the pandemic, and increased inventories in response to this. As a whole, the need for fixed capital in contract manufacturing is low, as the nature of the business is personnel-intensive and the equipment base is considerably lighter than, e.g., in the conventional process and engineering industry. In light of this, fixed equipment investments in the industry have typically been implemented in a fairly linear manner relative to demand wall and floor space permitting. This in turn has both improved the efficiency of capital allocation of contract manufacturers (i.e. ramp-up and -down of new investments is quick) and helped companies avoid long-term overcapacity situations that are unpleasant for margin levels. In addition, acquisitions in the sector have typically taken place with moderate valuation multiples of around 7x EV/EBITDA, depending on the target, which has limited the accumulation of goodwill in balance sheets (and kept ROIC at good levels) that slows down the turnover of capital employed.

Cash flow is directed at working capital and acquisitions

Given the comparatively low fixed capital requirements of contract manufacturers, net working capital (except for Hanza) accounts for most of the companies’ invested capital. For the examined manufacturers, the share of net working capital in total invested capital has historically been between 60-70% and the turnover has been 4x-5x (i.e., 20-25% as revenue). In other words, increasing revenue by EUR 1 million requires on average EUR 0.2-0.25 million of financing in working capital from the companies, and especially in times of strong organic growth it is necessary to tie capital to inventories and thus to own delivery capacity/customer relationships in the industry. Thus, the business of contract manufacturers is quite working capital intensive, at least in the key sectors of Nordic contract manufacturers (high mix/low volume).

Source: Company materials, Inderes

Overall, the return on capital of the companies we examined has been excellent over time and we estimate that they have been quite clearly above required returns. Especially noteworthy in generated returns is that reflecting the high margins on capital (absolute operational earnings growth/absolute increase in capital employed), are not merely the result of the good capital stock of old investments reduced by annual depreciation. In other words, we believe that the companies we have chosen have also succeeded in their new investments.

However, the key question for value creation in the coming years is unsurprisingly whether companies will be able to continue to reallocate free cash flows back to the business at a higher return than the cost of capital and how large the gap between expected returns and cost of capital can be kept. We assess that the companies have good prerequisites for value creation, as the green transition and the increase in the outsourcing rate of industrial electronics keep the organic growth outlook favorable (projected global market growth above 5% per year on average). In addition, the fragmented European contract manufacturer field offers favorable opportunities for capital allocation through acquisitions, which all the companies included in our review have taken advantage of in recent years. Thus, we do not see an immediate end on the horizon to the strong value creation among contract manufacturers that started in the 2010s, but it is likely that there will be differences between companies, e.g., through successful acquisitions and the varying success of customer companies.