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Benchmark Electronics: Disguised
Transformation Sets Up ~100% Upside
Opportunity
|Must Read Aug. 17, 2016 9:00 AM ET8 comments
by: Lester Goh
Summary
• Electronics contract manufacturers are mostly indistinguishable from one
another. As a result, both the Street and the market appear to price players
superficially.
• The market is not pricing in Benchmark Electronics' on-going transition to
higher-value markets.
• Fair value of ~$50 or ~100% upside.
• Striking similarities between players makes for an unusually strong catalyst.
Benchmark Electronics: Disguised Transformation Sets Up ~100% Upside Opportunity… Page 1 of 13
http://seekingalpha.com/article/3999962-benchmark-electronics-disguised-transformation-… 20/8/2016

• Downside protected by incrementally stable cash flows, a large discount to
key comp Plexus, a clean balance sheet and a highly variable cost structure.
Electronics contract manufacturers ("ECMs") or electronics manufacturing service
("EMS") firms are an interesting group to keep track of in search of value. Why?
Simply because most players are indistinguishable from one another.
Take Sanmina (NASDAQ:SANM) and Jabil Circuit (NYSE:JBL) for example. Both
manufacture products according to OEM specifications. While they do some design,
they readily admit manufacturing to specifications is the bulk of their operations.
Both serve similar end-markets - mostly networking, telecommunications and
automotives, not so much industrial, defense and aerospace. Long-lived assets (i.e.
PP&E) for both are also overwhelmingly non-U.S.
While the two do not offer similar disclosure, their financials do suggest they likely
have similar exposure to each individual end-market. According to Morningstar data,
SANM does 7-8% gross margins and 2.5-3.5% operating margins while JBL
manages 6.5-8.5% and 2.5-3.5%, respectively. Absent the fact that JBL does ~3x
the sales of SANM, one can conclude that both firms are terribly similar.
Hence, it should come as no surprise that both firms are priced similarly in the low-
to-mid teens range. JBL's market cap is roughly $4b and its LTM net income is
~$300m, so its P/E is ~13.3x. On headline numbers, SANM goes for ~5x P/E (~$2b
/ LTM ~$400m in net profits). But SANM is temporarily over-earning due to the
release of its valuation allowance - ~$289m in '15, ~$88m in '14 - which led to
~$201m and ~$35m of tax benefits in '15 and '14, respectively. Excluding these
effects shaves ~$201m off LTM net profits, bringing SANM's P/E to ~10x.
Clearly, the fact ECMs are fairly similar to one another makes analysis and valuation
rather simple. Another shortcut which relates to valuation centers around end-
markets served.
If an ECM does a lot of computing, networking and telecommunications work (i.e.
enormous, and thus, extremely competitive markets), gross margins will cluster
around 6-8%, operating margins will dance around 2.5-3.5%. Suffice to say, SANM
and JBL are exhibit A and B here. They will often be priced at a low-to-mid teens
P/E.

On the other hand, if an ECM has greater exposure to the industrial, defense,
healthcare and aerospace end-markets (i.e. smaller, less competitive areas), they
will do 9-10% gross margins, and 4-5% operating margins. Plexus
(NASDAQ:PLXS), who gets ~70% of its sales from the aforementioned markets, fits
the bill. Such firms will be priced at a high-teens P/E - shares of PLXS change
hands at ~19.2x P/E (~$1.56b / LTM ~$81m in net profits).
Against such a backdrop, the reader should easily conclude that the EMS space
does not attract deep sell-side attention. Because of the ease of analysis and
valuation, the Street is enormously superficial in its valuation of EMS players. If you
manage to get hold of Deutsche Bank's (NYSE:DB) EMS industry report authored
by Sherri Scribner, you'd find I'm hardly joking. Here is how she justifies Benchmark
Electronics' (NYSE:BHE) ("Benchmark", "BHE", or "the Company"), the subject of
this report, valuation (emphasis mine):

In general, EMS stocks have historically traded at similar
P/E ratios, and we believe earnings coupled with a
review of balance sheet and return metrics is the
best way to value EMS stocks. Since 2004, EMS
company P/Es have averaged 13x, largely in line with
market multiples, with a range of roughly 3x-20x. We
believe an 8-15x multiple is more appropriate for EMS
shares at this time, with smaller EMS companies
trading at the high end of that range due to faster
revenue growth and higher operating margins. Our price
target is based on Benchmark trading at 14x our FY-
15 EPS estimate, which is in line with peers. With the
shares currently trading near these levels, we rate
Benchmark a Hold."
Source: Deutsche Bank EMS Industry Report
In short, a myopic focus on current earnings, a look at the balance sheet, returns
and little else. The reason for my emphasis on the word 'current' is because it is
central to why I believe BHE is mispriced.
I note she applies exceedingly similar phrasing when valuing other players in the
space (e.g. Celestica, Fabrinet, Flextronics, JBL, PLXS and SANM) so this is not an
isolated case.

In her defense, a sell-side analyst's time would be better spent covering the OEMs,
given they are the 800 lb gorillas (e.g. Apple). Suffice to say, such superficial pricing
of EMS players by the market and the Street can create interesting opportunities.
Benchmark Electronics - Perception: SANM/JBL, Reality: PLXS
Core to my thesis on BHE is that on headline financials, the Company looks very
much like SANM and JBL and trades similarly, but in reality Benchmark is more like
PLXS.
BHE's 7-9% gross margins and ~3-3.5% operating margins nearly mirrors that of
SANM and JBL. The market clearly perceives Benchmark to be a close replica of
the two, given the Company trades at ~14.3x P/E (~$1.2b / LTM ~$84m in net
profits).
However, said financials do not square with the fact as of 2Q '16, ~63% of sales
stem from higher-value medical, industrial (incl. aerospace & defense), test, and
instrumentation markets, up from ~55% in '15, ~50% in '14, and ~32% in 2007. The
question is, why then do we not see this in Benchmark's gross and operating
margins?
Before moving on, note the classifications 'higher-value' markets and 'traditional'
(telecommunications and computing) markets were present only in the '15 annual
report onwards and not the '14 report. Hence, most market participants would have
likely missed the change in disclosure and, more importantly, a sign the Company's
strategic priorities have shifted. As the classification implies, 'higher-value' markets
carry fatter margins as compared to 'traditional' markets.
Program Dynamics: Nuances Between 'Traditional' & 'Higher-Value' Markets
Key to understanding what I believe the market is missing is figuring out nuances
between program dynamics in different end-markets.
Serving 'traditional' markets such as computing is not design-intensive from the
perspective of an ECM. This is because the customer (e.g. IBM) does all of the
designing. The ECM is just there to manufacture according to a standard design; in
other words, there is little value added by the ECM. Combine minimal value-add, a

standardized design and large markets, you get brutal competition. This is why
ECMs with huge exposures to these commoditized markets earn low single-digit
operating margins.
Importantly, there is minimal time lag to production because the customer has
already done the designing, prototyping and testing beforehand. The ECM just has
to obtain manufacturing qualifications before initiating production; qualification is
rarely time-consuming because of a standardized design. Upfront investments in
capacity by the ECM pay off very quickly because time-to-market is minimal. There
are no cost-revenue timing problems.
On the other hand, the dynamics are starkly different for 'higher-value' markets such
as aerospace and healthcare. The model here differs from that of 'traditional'
markets as it involves intensive customer collaboration at the earlier stages (i.e. at
the proof of concept, design and prototyping phases). Products in aerospace and
healthcare (and other 'higher-value' markets) are also often low-volume, highly
complex, extremely customized and require unparalleled reliability. As a result,
qualifications and certifications are much harder to obtain in these markets as
compared to 'traditional' markets. Without a doubt, the combination of these factors
is a recipe for bigger margins. Hence, ECMs who concentrate in these markets earn
mid single-digit operating margins.
Crucially, there is considerable time lag to production as customers work with ECMs
to design, test, and prototype products before giving the green light to
manufacturing. Qualifications and certifications are also a time-consuming process
due to the stringent reliability requirements (FAA for aerospace, FDA for healthcare,
etc.), product complexity and heavy product customization. Thus, upfront
investments in capacity take several quarters to pay off due to these dynamics,
leading to a cost-revenue timing problem. Management offers some color on this
problem (emphasis mine):

Our recent investments to enhance our sales, marketing
and engineering efforts in support of our business
strategies are impacting our current and near-term
margins. These intentional SG&A investments impact
our short-term performance while they lay the
foundation for future growth in our targeted markets
building a richer margin profile."
Source: 2Q '16 Earnings Call Transcript
Uninformed observers would see the massive increase in OpEx at BHE in the last
decade as a gross mismanagement of costs. 2006 sales were just south of $3b
while LTM sales are ~$2.5b, yet OpEx has nearly doubled from ~$70m in 2006 to
~$130m on a LTM basis. The market clearly sees it that way - with costs ballooning
and net income being more or less flat, the stock has traded in a range for much of
the last ten years.
However, those who are able to suss out the nuance between 'traditional' and
'higher-value' markets would arrive at a dramatically positive conclusion. In the past
few years as BHE transitioned to serving 'higher-value' markets, it has been
investing heavily in OpEx. Results from these OpEx investments are not
apparent in its financials because 'higher-value' markets have drastically
longer 'gestation' periods before revenues hit the P&L. Essentially, BHE is
intentionally taking a margin hit today, for greater profits tomorrow.
This explains why as of 2Q '16 ~63% of sales stem from 'higher-value' markets
while '15 bookings mix from these markets have already exceeded 70% and is
~77% as of 2Q '16. The Company has been consistently winning ~$115m-$125m in

new programs in recent quarters, the majority of which is likely to be related to
'higher-value' markets given the trends in its bookings mix. However, this does not
explain why sales growth has been anemic.
The chief reason why revenue growth has been uninspiring is because the
Company has been shedding low-margin customers in 'traditional' markets as work
there is highly commoditized and no longer meets BHE's hurdle rates. In 1Q '16,
management decided not to participate in next-gen programs with its top telco
customers because returns were unsatisfactory. Telco sales declined in 2Q '16 as
Benchmark completed legacy programs. Telco spending has also been lackluster as
of late - 2014 was a huge year for telco spending, but has seen broad-based
declines in 2015 as well as 2016 year-to-date. Hence, the shedding of low-margin
programs in 'traditional' markets as well as overall weakness in those areas
has hidden the progress of higher-margin programs in 'higher-value' markets.
Sales have also been gyrating wildly in the $2.4b-$2.8b range because 'traditional'
markets are volatile - a product of every random ECM wanting a piece of the very
large pie. Volatility in sales, of course, is not unique to Benchmark. Jabil was
similarly affected in late 2013 due to BlackBerry reducing purchases.
This volatility in BHE's results will be reduced with the passage of time as the
Company completes its transition to 'higher-value' markets where switching costs
are high (due to the high costs of failure), which manifests itself in stable customer
demand over time.
Valuation & Asymmetry
In my view, shares of BHE are worth ~$50, or ~100% upside from current levels.
This corresponds to a 15x multiple on $2.88 in 2015 cash EPS ($147m / 51m
shares) and ~$7 in net cash ([$573m in cash - $229m in debt] / 51m shares). I'm
using operating cash flow as cash EPS here as the benefit from working capital in
2015 was minimal, thus OCF is more or less equal to net income + depreciation &
amortization + stock-based comp.
A 15x multiple represents a large discount to Plexus, despite the fact an argument
could be made for a similar multiple; BHE's exposure to 'higher-value' markets is
strikingly similar to PLXS, after all.

Why cash EPS? While cash EPS has been volatile during much of BHE's history,
the metric has stabilized recently as the Company got its working capital house in
order. Management has been emphasizing in recent earnings calls its intention to
minimize the firm's cash conversion cycle (emphasis mine):
During the quarter, we generated strong free cash flow,
our progress on our working capital initiates allowed
us to reduce our cash conversion cycle from 99 days
last quarter to 83 in the second quarter. I'm
encouraged by the solid performance from our teams on
these initiatives and the improvement we have made
during the past 18 months where we have implemented
more efficient demand management and supply chain
solutions. Our progress on these initiatives has been
strong but we have more work to do in this area. We are
on track to achieve our 75 day target as we exit the
fourth quarter."
Source: 2Q '16 Earnings Call Transcript
In particular, it appears the Company has material of room for improvement on this
front, given its DSO has been roughly 70 while DPO is around 43, versus a DSO of
48 and DPO of 60 for Plexus. In addition, cash EPS has been greater than net
income for the past 2 years (2014-2015) and hence seems to be a more appropriate
valuation metric.

My cash EPS estimate is based on 2015 numbers. Importantly, this assumption
implicitly includes the upfront costs relating to 'higher-value' markets, but excludes
the revenue benefit that has yet to hit the P&L due to the dynamics of said
markets, as discussed. This also implies a significant margin of safety with my
estimates.
What about downside protection?
'Traditional' markets tend to have deals competitively re-bid with each successive
product generation, while this is less common with respect to 'higher-value' markets
due to switching costs; in other words, revenue is more stable in latter markets.
Incremental stability and greater profitability not only support a higher valuation
multiple, but also offers meaningful protection on the downside.
Additionally, whereas BHE has net cash, SANM has net debt (though the number is
small), while JBL has ~$1b in net debt. As a result, the Company would likely be
hurt less in an economic downturn as compared to SANM and JBL.
Furthermore, it seems likely BHE would not be significantly impaired in a 2008-style
recession. From 2007 to 2009, Benchmark's revenue was cut by a third. While the
Company reported a GAAP loss in 2008, this was due to a ~$247m goodwill
impairment. Notably, BHE remained solidly operating cash flow positive throughout
the 2007-2009, thanks to its working capital releases and highly variable cost
structure. As a result, the Company did not have to engage in dilutive capital raising
activities in order to survive through the crisis - Benchmark actually spent ~$175m
buying back ~8m shares, thus reducing its outstanding share count by ~11%
throughout said period!
It is of vast importance to note a 2008-style crisis would have significantly less
negative impact on Benchmark going forward compared to what it went through in
the prior crisis, given its end-market exposure has shifted to more stable 'higher-
value' markets. Recall that sales from such markets comprised of ~32% of revenue
in 2007, as compared to ~63% of revenue as of 2Q '16. This change in exposure
should offer investors tremendous confidence the Company would not be severely
bruised by a downturn.
Catalysts & Risks
Benchmark Electronics: Disguised Transformation Sets Up ~100% Upside Opportunit… Page 10 of 13

The main catalyst revolves around the benefits of upfront investments relating to
'higher-value' markets accruing several quarters out. As relatively high-margin
revenue from said markets hit the P&L in coming quarters, BHE's headline financials
should look more like PLXS. In turn, the Company should be valued similarly.
Striking similarities between EMS firms makes for an unusually strong catalyst. This
is because it is likely easier for the market to recognize and correct a mispricing (i.e.
BHE's headline financials eventually mirroring Plexus') as it would be difficult to
make a strong argument against relative valuation given the firms in question are so
similar.
The largest risk to the thesis stems from whether the Company would actually
receive the benefits of its upfront investments in 'higher-value' markets.
In my view, this risk is severely mitigated by the fact that work in said markets are
collaborative by nature, making it hard to envision a scenario where the customer is
unhappy with the end-result.
Furthermore, the long sales cycle makes it risky for a customer to switch to a
different partner as the new partner would need to acquaint himself with the
customer's needs, which would place the customer at the starting line of the sales
cycle once again.
Finally, switching partners tends to be costly. Customers look for reliable sources of
supply to provide them with high-quality products. Therefore, if a customer is able to
procure high-quality products from a partner, it can dispense with incoming
inspection and testing, which saves considerable costs. As a result, customers tend
to be 'locked in' with a particular partner due to their dependence on established
sources of supply.
Recommendation: Initiate a position in Benchmark Electronics with a target
price of ~$50 representing ~100% upside from current levels. Downside is
protected by incremental stability of cash flows as the revenue mix shifts
towards 'higher-value' markets, a large discount to key comp Plexus, net cash
on the balance sheet and a highly variable cost structure.

Benchmark Electronics is, in my view, a highly asymmetric opportunity. The
Company has been unfairly penalized by the market as it sacrifices margins today
for greater margins tomorrow. This approach has led the market to wrongly lump
BHE together with firms such as JBL and SANM who although possess similar
margins, have drastically different, and arguably, poorer end-market exposures. As
the Company completes its transition to 'higher-value' markets, its financials and
stock price should begin to reflect reality.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate
any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving
compensation for it (other than from Seeking Alpha). I have no business relationship
with any company whose stock is mentioned in this article.
Additional disclosure: Disclaimer: The author's reports contain factual statements
and opinions. He derives factual statements from sources which he believes are
accurate, but neither they nor the author represent that the facts presented are
accurate or complete. Opinions are those of the the author and are subject to
change without notice. His reports are for informational purposes only and do not
offer securities or solicit the offer of securities of any company. Mr. Goh ("Lester")
accepts no liability whatsoever for any direct or consequential loss or damage
arising from any use of his reports or their content. Lester advises readers to
conduct their own due diligence before investing in any companies covered by him.
He does not know of each individual's investment objectives, risk appetite, and time
horizon. His reports do not constitute as investment advice and are meant for
general public consumption. Past performance is not indicative of future
performance.

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Benchmark Electronics Disguised Transformation Sets Up ~100% Upside Opportunity