EMS firms with higher ROCE may command premium valuations: JP Morgan
New Delhi, September 28
Investors could increasingly look beyond earnings growth to return on capital employed while valuing electronics manufacturing services companies, as firms with similar earnings growth but higher ROCE could command premium valuations according to a report by JP Morgan.
Strong revenue growth has driven a re-rating in price-to-earnings (P/E) multiples across the electronics manufacturing services (EMS) sector in recent years. However, the report noted that "one cannot ignore the ROCE of the business, given its capex-intensive and high-NWC (net working capital) nature and, hence, it has to be baked into the multiples as well."
JP Morgan argues in its report, companies with similar earnings growth and higher ROCE generate better returns on the capital deployed.
Accordingly, investors are expected to pay greater attention to ROCE if earnings fall short of expectations, growth moderates or working-capital requirements remain elevated, potentially putting pressure on free cash flows.
"In our view, the market will start looking at ROCEs once (1) there is a miss on earnings, (2) growth slows down, and (3) NWC remains high, thereby negatively impacting FCF," it said.
It also noted that recent investor interest in semiconductor-related opportunities has supported valuations in parts of the EMS sector, although revenue from such opportunities could scale up gradually.
The report highlighted a similar trend late last year, when a revenue growth miss and an increase in working-capital days at an EMS company led to negative cash flows, shifting investor attention towards balance sheets, cash flows and return on capital employed across the sector.
Furthermore, JP Morgan noted in its report that some electronics manufacturing services (EMS) stocks have rallied sharply over the past one-and-a-half months, partly supported by new orders from US clients in semiconductor equipment manufacturing and growing investor interest in semiconductor-related opportunities.
However, revenue from these orders is expected to scale up gradually. The report cautioned that parts of the EMS sector are now trading at significant price-to-earnings (P/E) premiums despite having broadly similar earnings growth expectations and relatively lower return on capital employed (ROCE), raising concerns over valuations.
— ANI
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