High ROCE Could Drive Premium Valuations for EMS Firms: JP Morgan
JP Morgan report suggests investors will prioritize ROCE over earnings growth when valuing electronics manufacturing services companies.
In the rapidly evolving electronics manufacturing services (EMS) sector, the traditional focus on earnings growth may be shifting. According to a recent report by JP Morgan, investors are likely to place a much higher premium on Return on Capital Employed (ROCE) when determining the value of these companies.
While strong revenue growth has historically fueled a re-rating of price-to-earnings (P/E) multiples across the sector, the brokerage warns that earnings alone do not tell the whole story. Because the EMS industry is inherently capital-intensive and requires significant net working capital (NWC), the efficiency with which a company uses its capital is becoming a critical metric for the market.
The Shift from Growth to Capital Efficiency
The JP Morgan report suggests that when two companies show similar earnings growth, the one with the higher ROCE is likely to command a superior valuation. This is because higher ROCE indicates a superior ability to generate returns on the capital deployed within the business.
The brokerage identified three specific scenarios where investors are expected to pivot their attention toward ROCE:
- Earnings Misses: If a company fails to meet its projected earnings targets.
- Growth Moderation: When the rapid pace of revenue expansion begins to slow down.
- High Working Capital: If net working capital requirements remain elevated, which can put significant pressure on free cash flows (FCF).
"In our view, the market will start looking at ROCEs once there is a miss on earnings, growth slows down, and NWC remains high, thereby negatively impacting FCF," the report stated.
Lessons from Recent Market Volatility
This shift in investor sentiment is not purely theoretical. The report pointed to a trend observed late last year, where a specific EMS company experienced a revenue growth miss alongside an increase in working-capital days. This combination resulted in negative cash flows, forcing investors to look past top-line growth and scrutinize balance sheets, cash flows, and capital returns.
The Semiconductor Influence and Valuation Concerns
The EMS sector has recently seen a surge in interest, driven largely by opportunities in semiconductor-related manufacturing. Some stocks have experienced sharp rallies over the last six weeks, bolstered by new orders from US-based clients in the semiconductor equipment space. However, JP Morgan cautioned that revenue from these specialized orders is expected to scale up only gradually.
Furthermore, the report raised concerns regarding current market pricing. Some segments of the EMS sector are currently trading at significant P/E premiums. This is particularly noteworthy because these high valuations are being applied to companies that have broadly similar earnings growth expectations but relatively lower ROCE compared to their peers, potentially signaling a valuation risk for investors.