On Sept. 1, the U.S. implemented a 15% tariff on, among other goods, networking gear, storage devices, and wearables imported from China. On Dec. 15, additional tariffs on other tech hardware, including smartphones, notebooks, and videogame consoles are slated to go in effect. These goods—on what the government calls List 4—essentially includes all Chinese imports not already subject to tariffs. Already, goods of various sorts listed earlier, and representing about $250 billion of imports, currently carry a 25% tariff, which the U.S. proposes to increase to 30% on Oct. 1. While those goods—Lists 1,2, and 3—include hard disk drives, routers, switches, and modems, the technology sector overall was less affected than other sectors and these tariffs did not affect the financial performance of Flex Ltd. and Jabil Inc. in a major way. However, tariffs on the broader scope of List 4 technology products would have a much greater impact.

We think that in the absence of a trade deal, tariffs are likely to weaken financial performance as the companies' OEM customers ask them to share some of the burden, price increases to end-users destroy some demand, and a weakening global economy hurts IT spending. Flex's and Jabil's business positions could improve as customers move some production out of China, making supply chains more complex and increasing reliance on outsourced manufacturing providers. However we think they will have trouble converting that improved position into higher profits in the near term because of the pressure new tariffs would create. Finally, we believe that the 'BBB-' rating is important to both companies and that they have the willingness to manage their financial metrics to be in line with their ratings. Furthermore, we believe that in a 15% tariff scenario that they would have the ability to preserve their ratings, but that a 30% tariff could put the ratings at risk.

Revenue Exposed To Tariffs

We estimate that goods affected by current and proposed tariffs on Lists 1, 2, 3 and 4 represent about 6% to 9% of Flex's revenues and 12% to 17% of Jabil's, based on our estimates of each company's mix of U.S.-bound products made in China. Neither company discloses these figures so we estimated them based on a review of revenue by geography for each of the customers they name in their annual reports.

Flex reports revenue by country of manufacture on a quarterly basis. In fiscal 2019 ending in March, 25% of revenue came from manufacturing operations in China, and it is trending down with 23% coming from China in the quarter ended June 28, 2019. We expect this figure to be in the low-20% area in fiscal 2020 as some customers shift production out of China and as it winds down its relationship with Huawei.

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We estimate that Jabil derives 40% to 50% of revenue from manufacturing in China. Jabil's reporting is less straightforward that Flex's. It reports revenue by the location where the relationship is managed and the sale transacted, rather than by the location of manufacturing, so this metric is not useful for our analysis. Long-lived assets in China represented 43% of the company's total assets in fiscal 2018 (ending in August), and China represented 51% of its owned and leased square footage. These figures inform our estimated range of 40% to 50%. We expect Jabil's revenue from China will fall modestly in fiscal 2019 since 2018 included a strong iPhone cycle.

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We also estimate that the percentage of revenue for products manufactured in China and shipped to the U.S. as a percentage of total China production is in the high-30% area for both companies based on an analysis of the percentage of revenue from the U.S. of each company's named customers.

For Jabil, Apple's share of revenue from the U.S. is 37%; the simple average of the other nine named customers is 39%, while the U.S. dollar weighted average is 37%. For Flex, the simple average of its named customers who file financials publicly is 37%. The U.S. dollar weighted average is 45%. But excluding Ford Motor Co., the average is 37%. We think excluding Ford from the weighted average is analytically valid because for Ford, Flex only manufactures a small piece of a very expensive product, whereas it manufactures a much larger piece of the final products of its other customers. However, we think the high-30% area is likely to be a high estimate of U.S.-bound China production because we expect that Mexico produces a greater share of U.S.-bound production than the global average. As such, our estimated ranges fall below the estimate implied by combining the high-30% estimate of U.S.-bound China production, with each company's estimated total China revenue.

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Relocating Production

The two companies diverge on whether to relocate significant production out of China.

On its October 2018 earnings call, Flex said that it believes that in expectation of new tariffs on a broad range of products it expected to move a significant amount of volume out of China into Mexico, Southeast Asia, and India. Since then, tariffs have escalated so we believe the statement is still valid. Jabil is saying something very different. On its earnings call in June 2019, it said that very few customers were moving existing production out of China because they have deep-rooted and mature supply chains, they don't see a reasonable payback, and a decent share of its Chinese-made products are not U.S.-bound.

In general, we think that Flex's statement is more consistent with the views of most U.S. technology hardware companies, including Cisco Systems Inc., Juniper Networks Inc., and CommScope Inc., all of whom have already or are planning to move some production out of China. Jabil's statement is likely particular to its own customer base, including Apple, whose supply chain we view as fixed in China in the near-term give its large size and complexity.

The 15% Tariff Is Manageable

Several factors contribute to our view that a 15% tariff on List 4 products would be manageable. First, the tariff is not on the final price to the end-user, but on the value of the product as it exits China, which is a value closer to the OEMs' cost of goods sold. If a particular product has a 50% gross margin, the tariff would likely amount to a value closer to 7.5% of the price to the end-user. Next, only a portion of Chinese production is bound for the U.S. We estimate that U.S.-bound Chinese production represents a 6% to 9% share of total revenue for Flex, and a 12% to 17% share for Jabil. In addition, the Chinese currency has already weakened about 3% since the announcement of the List 4 tariffs, offsetting some of the impact. Finally, we expect the tariff burden to be shared by many stakeholders. End-users will see some price increases. The OEMs will take some impact in the form of lower margins. And the supply chain will share the rest. The EBITDA margins of the outsourced manufacturing providers is already low (in the 5% to 7% range) and they require significant capital expenditures, so they are not in a position to give significant concessions.

Our view that Flex and Jabil may have to bear some of the cost of the tariff is based on our expectation that the OEMs would negotiate price concessions. We don't believe that they have a contractual obligation to pay tariffs; we think that either the OEM pays directly when it is the importer of record or if the manufacturer pays as the importer, it can pass through the cost. However, it is possible that some customers may attempt to negotiate price concessions to pass on some of the tariff cost. If their customers approached them with a reasonable concession request, for example one proportional to their share of profit within the value chain, we believe Flex and Jabil would accommodate the request in order to preserve the long-term customer relationship. We estimate the impact to total profit from this type of request across all its customers would be around 1% for Flex and around 2% for Jabil. In a more extreme scenario in which the OEMs have very good negotiating leverage and ask Flex and Jabil to accept a concession that is double its share of profit within the value chain, the impact would be around 2% of total profit for Flex and around 4% for Jabil. Even in the extreme case, we think a 15% tariff would be manageable.

We think a 30% tariff would be much more disruptive. More customers would want to move their production out of China, creating execution risk for both companies. New supply lines would also take time to reach maximum efficiency, temporarily decreasing yields and hurting profitability. In addition, there could be some demand destruction from price increases to end-users. Most important, the macroeconomic impact and the hit to business confident would likely hurt IT spending. The demand destruction and macroeconomic risks would result in lower volumes and could weaken profitability on negative operating leverage, creating the need for cost restructuring. Combining these factors with higher price concessions to the OEMs would create a significant headwind.

Weaker Finances, But Stronger Business Positions

We believe that the current and proposed tariffs could, for the factors already mentioned, lead to weakening financial performance over multiple years, although, perhaps conversely, the companies' business positions might improve.

Either a 15% or a 30% tariff case could hurt sales and profits at both companies. The key risk factors would be macroeconomic weakness that harms IT spending, demand destruction from price increase to end-users, and execution risk from reorganizing the supply chains of multiple customers at the same time. Nevertheless, we think Flex's and Jabil's business positions could improve because the increasing supply chain complexity would make customers more dependent on them. Both companies have large global footprints that give them local knowledge in multiple countries, deep domain expertise in multiple-end markets, sophisticated supply chain management systems, and the ability to support customers of any scale. We think these strengths would become more attractive in a world in which supply chains become increasingly complex. Finally, these scenarios might accelerate outsourcing in high-margin end markets like automotive, medical, and industrial, if these customers don't want to manage increasing supply chain complexity and would rather focus on product development and marketing. Nevertheless, we think the companies would have trouble translating their improved advantages into higher profits in the near-term due to the challenges the tariffs would create, particularly in the 30% scenario.

Downgrades Are More Likely At 30%

We expect that in the next quarter, Flex and Jabil will have cushion in the high-single digit percent area as a share of EBITDA relative to their downgrade thresholds of leverage above 3x. While the cushion is tight, particularly in light of trade and macroeconomic uncertainty, each company has tailwinds that should result in the cushion expanding to the mid- to high-teen percent range, providing more capacity to absorb the negative effects of trade actions.

Flex has an unusually large amount of restructuring and other one-time costs weighing down our adjusted EBITDA total, which is related to the winding down of its relationships with Nike Inc. and Huawei. We expect to see more normal levels of one-time costs in the following year. Jabil has grown revenue at a mid-teen percentage rate in each of the last two years. We expect the company to grow EBITDA by improving the efficiency of some of its recent business wins and to reduce its accounts receivable program balances, which have been stretched as a result of the new wins.

In addition, working capital provides some cushion during a downturn because it is countercyclical, and both companies are working-capital intensive because they own the inventory and have low margins, making their accounts receivables and inventory large relative to their cash flow. If revenues decline, working capital monetization should make meaningful contributions to cash flow, giving the companies additional capacity to manage credit metrics.

Most importantly, maintaining an investment grade rating is part of both companies' financial policies and historically, they have managed their financial metrics in line with their 'BBB-' ratings. We think they have the willingness to take action to maintain their credit metrics in a tariff scenario, for example by reducing share repurchases to preserve cash which we net against debt. But will they have the means to do so?

In a 15% tariff scenario, we feel fairly confident that they could manage their metrics to preserve the ratings, but in a 30% scenario, potential EBITDA declines could prove to be too severe. Before taking any action, we would consider each company's tariff mitigation and balance sheet management strategies. We wouldn't necessarily downgrade the ratings if leverage exceeded our threshold for a few quarters, especially if we believed the company had a credible path to reestablish leverage below our 3x leverage threshold. But if we believed credit metrics were likely to exceed our downgrade thresholds over a 24 month period, we could lower the ratings.