Electronic Contract Manufacturing A Mixed Rebound Electronic Contract Manufacturing Industry Reporte

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Electronic Contract Manufacturing A Mixed
ReboundElectronic Contract Manufacturing
Industry Reporter - July 2004

• Introduction to the Brereton Electronic Contract
  Manufacturing Industry Reporter
• The Brereton Industry Reporter is a quarterly
  journal designed to assist management and
  investors in the electronic contract
  manufacturing industry. The journal attempts to
  address and explain current and anticipated
  market influences, investor sentiment and the
  valuation implications of the economic
  environment including private company
  acquisition activity. By introducing quarterly
  data and highlighting critical market issues, we
  hope that the Brereton Industry Reporter can help
  management and investors gain effective insight
  into the valuation and organization of their
  business.
• Table of Contents
• I. Executive SummaryII. An Industry Divided
  The Divergence of Top and Mid-Tier Strategies
• III. The Tax Cut of 2003 A Gift to Private
  Business Owners?IV. The Asian PullV.
  Mergers and Acquisition Review
• Executive Summary
• In the present era of competition and technology
  driven business, companies are increasingly
  leveraging collaboration as a strategic tool for
  business growth. To succeed as an electronic
  contract manufacturer (ECM) in this low margin
  and high volume environment, you need to
  continuously design and build sophisticated
  products to beat the competition. This demands
  working across enterprise boundaries with speed,
  accuracy, innovation, and efficiency.
• Among the many trends confronting the electronic
  manufacturing industry, several issues and
  challenges have emerged as key determinants of
  success. In this issue we will focus on the
  growing gap between top-tier and mid-tier
  manufacturers, the continuing development of
  offshore manufacturing capabilities, and the
  rampant consolidation of mid-sized, niche
  manufacturers.

An Industry Divided The Divergence of Top and
Mid-Tier Strategies They trace their origins to a
simpler time, when outsourcing was not yet a
politically charged word. That was then. Today,
the electronics manufacturing services industry
is a cutthroat global business that operates on
razor-thin margins and has fundamentally
redefined relationships up and down the supply
chain. Indeed, many of the top-ranked ECM
providers dwarf their OEM customers. Take
Flextronics International Ltd. (Singapore), the
top-ranked company on the list of Top 50 ECM
providers (contact us for full list). By
encouraging its major customers to tear down
their vertical in-house manufacturing structures
in the 1990s, Flextronics absorbed manufacturing
operations and built itself into a 13 billion
powerhouse. Twelve short years ago, Flextronics
reported revenue of just 93 million. During the
past decade, Flextronics' annual revenue growth
has averaged 48. By contrast, the entire ECM
market grew by 27 during the same period. Is
Flextronics satisfied with its No. 1 position?
Not by a long shot. Indeed, the EMS provider has
been pushing for new revenue streams in areas
once closed to contract manufacturers. It has
expanded into medical and industrial markets and
has begun actively marketing itself as a
full-fledged original design manufacturer (ODM).
The company is adding new plants in China and
Malaysia to service new business that it expects
to win from OEMs in North America and elsewhere.
It is also engaged in discussions with Nortel
Networks Inc. (Toronto) for a previously
announced contract that could add 2 billion
annually to its top line. (Continued on Page 2)
Electronic Manufacturing Services MA Deal
Volume
2003 and 2004 have brought a resurgence in MA
activity
Source Capital IQ MA Database.2004 Estimated
from 232 deals as of 5/31/04.
We would like to invite your insight on these or
other industry related topics. Our contact
information is on the back cover.
2
Electronic Contract Manufacturing Industry
Reporter - July 2004
An Industry Divided The Divergence of Top and
Mid-Tier Strategies (Continued) Another Distinct
World Most of the recent growth in the ECM market
has been concentrated at a handful of the largest
companies, mainly because they count the top OEMs
among their customers. The 50 biggest companies
accounted for 87 of the sector's global revenue
of 90 billion in 2003, according to Electronics
Supply Manufacturing estimates. Analysts
believe hundreds of companies operating in the
electronics sector describe themselves as ECM
providers, though many of those are largely
pc-board and subassembly services providers.
These companies' revenues hardly register on most
analysts' radar. Revenues in the sector range
from the billions to the hundreds of thousands.
Only the top 11 companies can boast revenue of
more than 1 billion. While most top-tier ECM
providers appear to have recovered from the 2001
downturn, it's a different picture among their
mid-tier rivals, which we define as companies
with sales between 25 and 250 million. Since
2000, several ECM providers with annual revenue
below 1 billion have disappeared some filed for
bankruptcy, and others were gobbled up by bigger
rivals (We will detail some of these acquisitions
later). Many ECM providers are still struggling.
For instance, 17th on the list, Pemstar Inc.
(Rochester, Minn.), and 29th, SMTC Corp.
(Toronto), have seen dramatic revenue declines
after major OEMs began consolidating their
manufacturing operations at the top-tier contract
manufacturers. The fact is, mid-tier contract
manufacturers are struggling to carve out a new
role for themselves. In many cases, these
companies have had to branch out into specialized
fields, such as medical equipment and industrial
automation systems. Targeting low-volume,
high-precision markets, these mid-tier ECM
providers can distinguish themselves and often
blaze the trail for the whole sector, according
to industry executives.

Top 50 Snapshot As clearly outlined below, the
top-tier manufacturers were the only group to
grow incremental revenue in 2003. While much of
this was organic growth, an increasingly
aggressive acquisition strategy is also often a
factor. It is also interested to
note that twelve of the top twenty-five
manufacturers are foreign, eight of which are in
Asia. Our next segment discusses this trend in
more detail. Source
Electronic Supply and Manufacturing.

We would like to invite your insight on these or
other industry related topics. Our contact
information is on the back cover.
3
Electronic Contract Manufacturing Industry
Reporter - July 2004
The Tax Cut of 2003 A Gift to Private Business
Owners? Basic Tenets of the New Tax BillNarrowly
passed by the Senate, President Bush has called
the tax cut "a vital action" that will stimulate
the economy and create jobs. Just how big a cut
is it? The new tax bill contains a 10-year, 350
billion tax cut, making it the third-largest tax
cut in the nation's history. While there are
many components of the Bill, ranging from
marriage penalty reductions to child credit
increases, business owners will likely be most
affected by two provisions relating to the sale
of their business 1. The capital gains tax
rate cut. 2. The rate cut on shareholder
dividends. Among other provisions, the Bill
temporarily reduces the rate on both corporate
dividends and capital gains. The Bill lowers the
rate on income from dividends and net long-term
capital gains to just 15 for individuals. The
new Bill marks the first time in at least the
past 60 years that we can enjoy a capital gains
tax rate below 20. In addition, it is the first
time that dividends are taxed at rates below
income tax rates. But, these benefits are
temporary. Both rates are subject to a sunset
clause. The reduced rates are due to expire after
2008 and revert to current levels in 2009. The
tax cuts could affect the private business owner
on several levels. At a macro level, if the tax
bill does its job, businesses and MA could
benefit from a boost in the economy. The tax
changes also produce direct financial benefits
when selling a business. We estimate that under
the new capital gains tax rate, most business
owners will see a 5-8 increase in their
after-tax proceeds following a sale. There is
also the potential for tax savings from the
change in the dividend income tax rate. Under the
new bill, the rate is dropping from a maximum of
38.6 (personal income tax) to 15, a 61 decline
in the rate for eligible dividends. Private
business owners looking to partially cash-out may
be able to initiate a self-recapitalization so
that the returns are treated as dividends and are
taxed at the new, lower tax rate. Whether a
company is structured as an S-Corp or a C-Corp
and initiates a traditional recapitalization, a
self recapitalization or an outright sale, the
bottom line is that this tax bill creates new
opportunities for the private business owner to
partially or fully exit his company in a tax
advantaged manner. (Continued on Page 4)

• The Asian Pull
• The practice of outsourcing electronics
  manufacturing gained popularity in the 1970s -
  largely in the United States, and today most of
  the worlds largest contract manufacturers are
  headquartered in North America. Yet the never
  ending search for lower cost manufacturing has
  prompted these companies to shift manufacturing
  to other regions--primarily to Asia. In fact,
  electronics manufacturing strategist Technology
  Forecasters Inc. (TFI) estimates that today more
  than a third of the worlds outsourced electronic
  products are built in China, and that by 2007 the
  portion will increase to half.
• While further off-shore manufacturing is commonly
  expected, there are several issues that have
  dampened growth expectations, these include
  intellectual property protection, quality and
  design concerns and specific customer service
  capabilities.
• Technology Forecasters recently conducted a
  survey to identify what contract manufacturing is
  expected to remain in North America. These are
  the top categories
• Medical products
• Aerospace/Defense products
• Products with high intellectual property
  content
• Homeland security products
• Products requiring collaboration with design
  teams
• Design services

We would like to invite your insight on these or
other industry related topics. Our contact
information is on the back cover.
4
Electronic Contract Manufacturing Industry
Reporter - July 2004
The Tax Cut of 2003 A Gift to Private Business
Owners? (Continued) Lets examine the effect of
the capital gains rate reduction on a business
sale. The maximum capital gains tax rate will
fall from 20 to 15, resulting in greater
after-tax proceeds following the sale of a
business. The following example shows the
effect of the new tax rate on a hypothetical
business sale. In this example, the company sells
for 8 million (on a debt-free basis). Because of
the difference in tax structures between an
S-Corp and a C-Corp, the capital gains tax
reduction will have a varying degree of impact on
individual companies. Let us assume that the two
companies in our example are identical, with the
exception that one was a C-Corp, and the other an
S-Corp, from inception. Both companies were
started with an initial investment of 100,000
and no additional outside capital was invested
thereafter. Both companies have book equities of
2 million (with neither company using
accelerated depreciation) and 2 million in debt.
Because of their different tax structures, the
taxable basis for the two companies is different.
For the S-Corp, the basis in the company's stock
is equal to the firm's equity, 2 million (the
basis in the company's assets is 4 million). For
the C-Corp, the basis in the company's stock is
simply equal to the initial investment, 100,000
(the basis in the company's assets is 4
million). The following example shows the effect
of the change in the capital gains tax rate on
our hypothetical business sale, whether the
company is structured as an S-Corp or as a
C-Corp. In the above example, under
the new tax rate, the net due owner to our S-Corp
seller increases 3.9. The net due owner gain for
our C-Corp seller is even more dramatic, 6.2. In
other words, in this example, the new capital
gains tax rate results in the seller keeping
about an additional quarter of a million dollars
when he sells his company. This tax bill, while
encouraging, is not the final word on taxes. In
the case of dividends and capital gains, the rate
cuts are effective only through 2008. Whether or
not the new rates will be extended beyond that
date, or raised before that date, is anyones
guess. Some believe the cuts will be made
permanent beyond the sunset date. Others
believe the rates will rise again, citing the
narrow margin by which the Act passed, and
considering that the Fed will soon be wrestling
with a way to fully fund Social Security
retirement and Medicare benefits for the baby
boom generation. The new Bill marks the first
time in at least the past 60 years that we have
enjoyed a capital gains tax rate below 20. In
addition, it is the first time that dividends are
taxed at rates below income tax rates. Because it
can take anywhere from 6-18 months to sell a
business (on average, one year), business owners
thinking of selling should prepare for market
now, so they can take advantage of what we
believe to be a unique and probably impermanent
opportunity.
We would like to invite your insight on these or
other industry related topics. Our contact
information is on the back cover.
5
Electronic Contract Manufacturing Industry
Reporter - July 2004
Merger and Acquisitions Review The worldwide
electronics manufacturing services market
rebounded in 2003, as the worldwide electronics
market experienced a broad-based recovery. The
market is expected to continue growing even more
robustly in 2004, and then settle into solid
growth in the following years, according to
Electronic Trend Publications. They estimate
that total electronics assembly value was 648
billion in 2003 and will grow to 875 billion in
2008. Fueled by this huge market, Electronic
Trend Publication believes that the ECM industry
will grow from 140 billion in 2003 to 244
billion in 2008. As seen on page one, 2003 and
the first half of 2004 has been a very active
time for electronic manufacturers in terms of
mergers and acquisitions (MA) activity.
However, it should be noted that while there are
more deals getting done, they are generally
smaller transactions. Factors Affecting
Activity There are several factors that may
assist in the resurgence of deal activity within
the sector. Some of these factors
include Rebounding Credit Market The credit
markets remain tight, but they appear to have
bottomed out, as average total debt/EBITDA
leverage ratios in transactions rose to 4.0x in
2003. Acquisition financing continues to be
predominantly through asset-backed loans as a
majority of the debt component, however recently
lenders are showing increasing support for cash
flow lending, which should help stimulate deal
activity.
Increased Activity from Private Equity
Groups Despite a decline in fundraising in 2003,
analysts confirm that there is no shortage of
capital in the hands of private equity groups,
who still have an estimated 100 billion, raised
during the golden fundraising years of 19982001,
to invest. In fact, the abundance of uncommitted
capital has become an issue for private equity
firms, many of which are behind their forecast
investment pace. As a result, they are scrambling
to make investments in quality companies.
Private Equity Groups are actively looking for
attractive electronic manufacturing companies
with stable cash flows to invest in. This is
exemplified by the recent barrage of deal
activity. Increase in Offer Multiples Not only
have the number of middle-market deals increased,
but offer multiples have risen as well. In 2003,
the International Mergers and Acquisition
Partners (IMAP) reported a jump of over 20 in
EBIT multiples. They also reported an average
hi-tech, non-proprietary EBIT multiple in 2003 of
5.5x.
Source Loan Pricing Corporation (A Reuters
Company)Transaction 100 millionBorrower
Revenues 500 million

• Multiples of Earnings Before Interest and Taxes
  (EBIT) were used in the comparisons above. EBIT
  was calculated using trailing 12 months earnings
  before interest and taxes, adjusted for
  non-recurring expenses and discretionary owner
  distributions including compensation in excess of
  market rates. Seller notes, etc., were discounted
  present values.

We would like to invite your insight on these or
other industry related topics. Our contact
information is on the back cover.
6
Electronic Contract Manufacturing Industry
Reporter - July 2004
Merger and Acquisitions Review (Continued) Recent
activity reflects the strong interest from both
strategic and financial buyers. It should be
noted that in the last twelve months, publicly
traded electronic manufacturers have seen a 48
increase in valuation, providing a much more
effective acquisition currency.
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Electronic Contract Manufacturing Industry
Reporter - July 2004
Merger and Acquisitions Review (Continued)

8

Brereton and Company is a boutique investment
bank dedicated to maximizing the value and
liquidity of closely held businesses.

• Strategic and Financial advisors to businesses
  seeking value Maximization
• Hands-on attention from experienced senior
  dealmakers who stay with your deal to closing
• Founded in 1995 drawing from prior investment
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• Empathetic professionals who have acquired,
  operated and divested businesses for their own
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• Broad industry experience in middle market
  Mergers Acquisitions
• Strategic planning framework for evaluation of
  financial alternatives
• Structured timelines and processes for multiple
  bidder-based value maximization

Attention
Expertise
Process

• If you are
• Undercapitalized and experiencing explosive
  demand for your product
• Facing a difficult transition after many years at
  the helm
• Unsure about how to best maximize the value of
  your business for your heirs
• Ready to harvest your business investment to
  diversify your net worth
• Please give us a call. Our initial discussions
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Brereton and Company, Inc.1075 N. Tenth Street,
Suite 110San Jose, CA 95112www.brereton.net
Brandt Brereton, Managing Director E-Mail
brereton_at_brereton.netTelephone [phone]
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Acquisitions Partners (www.imap.com)