We are raising our near-term rating on Sanmina Corp. (NGS: SANM) to BUY from HOLD and reiterating our long-term BUY rating. In our view, Sanmina is positioned for growth in high-value and mission-critical markets, resulting in peer-leading margins and prospect for sustained EPS growth.
SANM rose 1% in a rising market on 2/3/21 after the company posted fiscal 1Q21 (calendar 4Q20) earnings that topped analysts’ expectations, but revenue that fell short of consensus. The revenue miss was modest within a 5% top-line decline, but Sanmina delivered double-digit growth in adjusted EPS while significantly topping consensus. Building on momentum from the end of fiscal 2020, Sanmina again generated high gross margins exceeding 8.3%. Margins at that level are above those of peers (with Jabil in the high 7% to low 8% range and Flex in the low to mid-7% range). Margin gains were again led by Sanmina’s Components, Products, and Services segment, representing high-value-added capabilities in the contract manufacturing space. Sanmina has deliberately shifted its end-market business mix toward mission-critical and high-complexity solutions, where contractual relationships tend to run longer, enabling greater linearity and manufacturing efficiency. On a go-forward basis, we look for a 60/40 end-market split in which 60% of revenue is generated from high-value-added industrial, medical, A/D and automotive solutions; and 40% from slightly lower-margin communications networks and cloud infrastructure.
The 2Q21 comp will be against a deeply depressed year-earlier quarter in which the pandemic lowered sales by 25% from the prior year. Although component shortages could have an uncertain impact on near-term results, we believe that Sanmina can sustain growth in what we anticipate will be a normalized operating environment going forward.
Note that the sequential comparison was against a 14-week quarter. Among the four contract manufacturers or EMS companies (electronic manufacturing services) in Argus coverage, Jabil and Flex Ltd. generate $20 billion-plus in annual revenue, while Sanmina and Celestica generate less than $10 billion. To compensate for its smaller size, Sanmina has focused on profitability by targeting vital end markets and providing deep vertical capabilities beyond printed circuit board and box assembly.
Like-sized rival Celestica has struggled with its business mix and an historical overreliance on legacy enterprise hardware such as servers. By contrast, Sanmina has been proactive in lessening its reliance on technology markets, where margins are scant and contractual relationships are short. At the same time, it has increased its focus on high-complexity solutions in nontraditional mission-critical markets. As long ago as 2001, while most peers were technology-only, Sanmina acquired Alabama-based SCI with its focus on the space program and aerospace-defense. A/D has remained an important vertical for Sanmina, which has also built out its business in industrial, medical and automotive end-markets. Sanmina’s end markets and segments continue to recover from the pandemic-induced demand collapse that impacted fiscal 2020. CFO Kurt Adzema pointed out that revenue grew sequentially for a third straight quarter, adjusted for the 14-quarter fiscal 4Q20. More significantly, in our view, the adjusted gross margin exceeded 8% for a third consecutive quarter, putting the company alone atop our EMS coverage universe of Jabil, Flex, Sanmina, and Celestica. Off the elevated gross margin base, Sanmina is also the only EMS company in our coverage group that has delivered 5%-plus adjusted operating margins over the past two quarters. Sanmina looks at its business by end markets, but is organized via operating groups. While representing just 18% of revenue in fiscal 1Q, this business includes high-value-added vertical capabilities that provide margins well above those of traditional contract manufacturing services, and, as such, drives profit growth for the overall company.
CPS includes interconnect systems, precision mechanical systems, the global services and logistics business, SCI (aerospace & defense), and Viking (memory & storage). In years past, this business has frustrated investors with below-potential gross margin performance. From GMs north of 10% in FY14 and FY15, CPS GMs were in the 7%-9% range for most of FY16-FY18. CPS GMs improved in FY19, but only really came up to potential in late FY20. That margin progress carried over into 1Q21, as the adjusted gross margin of 12.4% was consistent with 4Q20. As we noted three months ago, that is the highest adjusted gross margin in our model dating back to the company’s introduction of this metric in fiscal 2011. Also for 1Q21, Integrated Manufacturing Solutions (IMS), representing the traditional electronic manufacturing services business, posted revenue of $1.46 billion (82% of revenue). IMS sales declined 5% year-over-year and 5% sequentially. The positively trending GM performance in both segments resulted in a blended non-GAAP gross margin of 8.3%, consistent with the 4Q20 level that was the strongest in our model since the dot.com.
Sanmina formerly reported three broad end markets of Communications, Cloud Solutions, and Industrial, Medical, Defense & Automotive. The company has now combined Communications Networks & Cloud Infrastructure (CN&CI) into a single unit. CEO Jure Sola, back in charge since August 2020, noted that end markets generally experience stable demand in the fiscal first quarter. Sanmina, which decades ago derived 70%-plus of revenue from communications, remains well positioned in IP routing and advanced optical. The company believes that 5G will deliver both in the short term and will be an accelerating long-tail opportunity in 2021 and 2022.
The cloud business is now primarily focused on high-end computing and data center storage solutions. Sanmina formerly had a large ODM ‘white-box’ server business. We believe that Sanmina is able to bring ODM expertise to high-end computing and data center storage, though less white-box and more customized to the needs of individual clients. The cloud business also includes remnants of Sanmina’s legacy enterprise exposure. This business has largely run-off legacy technologies, including point-of-sale devices tied to declining brick & mortar retail, and set-top boxes which are less in demand in the streaming era. According to the CEO, these businesses are now less than 2% of revenue and persist only within broader customer relationships.
In 2001, while most peers were technology-only, Sanmina acquired Alabama-based SCI with its focus on the space program and aerospace-defense. A/D has remained an important vertical for Sanmina, where its positioning in support of advanced communications, satellites and other areas has enabled Sanmina to supersede currently challenging industry trends. Sanmina has also built out its business in industrial, medical and automotive end-markets. After spring and early summer weakness in automotive, that market has begun to recover while remaining below past peaks. In the industrial space, normal seasonality and supply-chain issues could impact production. CEO Sola noted that Sanmina experienced some component shortages in fiscal 1Q21, but overall these were ‘manageable.’ In subsequent discussions with management, we sensed that component shortages could be a lingering issue across calendar 2021, with uncertain implications. Sanmina has deep experience juggling its supply chain as needed, which should help mitigate any shortages. Sanmina is currently celebrating its 40th year in business. The company was co-founded by Jure Sola and Milan Mandaric in 1980. Jure Sola is chairman and served as CEO until 2017. In October 2017, Bob Eulau – who
had been CFO since 2009 – became chief executive. Jure Sola was appointed by the board to resume his CEO duties.
The uncommon CEO turnover could be a matter of unfortunate timing and/or executive advancement; for example, Bob Eulau subsequently became CFO at Western Digital. Investors may perceive that longer-tenured CEOs at rival firms have time to develop and implement strategic roadmaps. While the uncommon pace of CEO turnover may raise concerns, at the end of the day we believe that operational metrics rather than management change is likely to drive the stock price over the long term. Additionally, no one knows Sanmina better than its founder, who is back in charge. CEO Sola has indicated his intention to remain chief executive; we do not believe there is an active search process. Ultimately, the market has treated this as a nonevent.
Looking out into early calendar 2021, the company sees broadly stable end markets and a 60/40 split between IMD&A and CN&CI. Management believes that Sanmina is well established in the ‘right markets,’ which include mission-critical, high-complexity, and in some cases heavily regulated, markets. Within the overall stable demand environment, industrial in fiscal 2Q21 is expected to show normal seasonal softness, while medical is consistent with recent periods. On the upside for the current period, automotive demand continues to recover, and Sanmina is benefiting from its strong position and contract growth in A/D. Demand remains stable in communications networks, with 5G driving growth, and IP and optical stable. In cloud infrastructure, high-end computing and storage are trending positively, while the legacy businesses continue to lag. Sanmina is positive on overall performance in fiscal 2021, based on industry-leading end-to-end solutions and strong customer partnerships. Beyond operational excellence, key priorities remain margin expansion and cash flow growth, along with maximizing shareholder value for the long term. Sanmina’s end markets are showing signs of recovery, and the company guided for sufficient revenue to generate a positive annual comparison in 2Q21. The fiscal 2Q21 comp will be against a deeply depressed year-earlier quarter in which the pandemic lowered sales by 25% from the prior year. Although component shortages could have an uncertain impact on near-term results, we believe that Sanmina can sustain growth in what we anticipate will be a normalized operating environment going forward.
EARNINGS & GROWTH ANALYSIS
Which was down 4% year-over-year and 5% sequentially; note that the sequential comparison was against a 14-week quarter.
In a repeat of 4Q20, non-GAAP EPS came in well above the top of management’s $0.75-$0.85 guidance range and $0.20 above the consensus estimate, which was based on management’s overly conservative guidance.
Which at the $0.81 midpoint would be up threefold from $0.32 in the pandemic-impacted fiscal 2Q20.
MANAGEMENT & RISKS
In mid-August 2020, Hartmut Liebel stepped down as CEO after less than a year on the job. Co-founder and Chairman Jure Sola has resumed the CEO role.
Both former CEO Bob Eulau and Hartmut Liebel lasted just 11 months on the job. We believe operational metrics rather than management change is likely to drive the stock price.