JP Morgan highlights the growing importance of return on capital employed in assessing electronics manufacturing firms, warning that rising valuations may face pressure without improving capital efficiency and cash flow performance.
Investors are likely to begin placing more weight on return on capital employed, or ROCE, when assessing electronics manufacturing services companies, as JP Morgan says firms with similar earnings growth but stronger capital efficiency could deserve richer valuations.
The bank said the sector has already benefited from a broad re-rating in price-to-earnings multiples, helped by strong revenue growth. But it argued that earnings growth alone does not capture the full picture in a business that is both capital-intensive and dependent on heavy working-capital needs. In JP Morgan’s view, ROCE has to be built into valuation work because the amount of capital tied up in the business affects the quality of those earnings.
According to the report, investors are most likely to turn more sceptical about low-ROCE companies if earnings miss forecasts, growth slows, or working-capital demands stay elevated and begin to weigh on free cash flow. JP Morgan said the market would probably focus more closely on returns on capital in those circumstances, rather than looking only at top-line expansion.
The report also pointed to a recent lift in sentiment for some EMS stocks, driven in part by semiconductor-related orders from US customers and broader enthusiasm for chip-linked themes. Even so, the bank cautioned that the revenue contribution from such work is expected to rise only gradually, which may limit the pace of any fundamental improvement.
JP Morgan also noted that some EMS shares have rallied sharply over the past six weeks or so, leaving parts of the sector trading on elevated P/E multiples despite broadly similar earnings-growth expectations. That, the bank warned, raises the risk that valuations could come under pressure if companies fail to show improving cash conversion and stronger returns on capital.
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