EMS prepares for its next phase
And now for something completely different
Barbara Jorgensen, illustration by Daniel Guidera -- EDN, December 1, 2004
As the electronics manufacturing services (EMS) industry tries to shake off the last effects of the recent downturn, its leaders are preparing for the next phase of growth. Two disparate strategies are beginning to emerge—both vaguely familiar. But the winning model, experts believe, lies somewhere in between.
Market leader Flextronics recently announced that it would expand its traditional service offering to encompass original design manufacturing, software design and a wider range of components. By doing so, Flextronics broadens its scope well beyond manufacturing into a broad array of vertically integrated services. By contrast, Flextronics competitor Celestica recently sold its power supply systems business to C&D Technologies, to instead focus on its core competency, manufacturing.
"There really are two models being executed here," says Jack Calderon, who heads up the EMS practice at investment bank Lincoln Partners. "Flextronics is moving toward vertical integration; companies such as Celestica, Jabil Circuit and Benchmark are not."
Ironically, it was OEMs' move away from vertical integration that paved the way for EMS companies to thrive. Stretched thin by making everything from their own chips to their end products, OEMs looked to outsource their noncore functions. Chip businesses were spun off or sold. Disciplines such as inventory management and logistics were parceled out to distributors. Assembly became the EMS companies' core competency.
Now market pressures are forcing some EMS companies to look beyond manufacturing. And the most-intense pressure is not coming from other outsourcing models—such as original design manufacturing (ODM; see "These Slim Margins Are Not by Design," September 2004)—but from profit margins. "A lot of people like to say that margins were driven down during the last downturn," says iSuppli analyst Adam Pick. "The truth is, these guys have been getting hammered from 1999 until about nine months ago." EMS gross margins have long hovered in the low single digits but recently hit historic lows, he says. In 1999 GPMs ran around 10 percent. Now, he says, they are running closer to 5 percent (see "EMS/ODM Margins Hit the Skids," below).
There aren't any easy ways to improve profit margins within the EMS industry, says Dan Hawtof, a vice president at iSuppli. However, over the past 10 months, several EMS executives, including Michael Marks of Flextronics and Mike Cannon of Solectron, have announced strategic plans to correct this eroding metric. Companies that have improved margins, Hawtof says, "have deployed multiple initiatives in parallel to drive efficiencies through their organizations" (see "Pump Up the Margins," below.)
Taken alone, any of these strategies can be problematic. "I personally believe that in the long term, vertical business models are not efficient," says Calderon. "To remain a competitive enterprise, you have to be the best in the world at everything you do."
In the classic electronics model, that means everything from designing components to assembling final systems. Businesses that are not best-in-class should be closed or sold off. "Day-to-day management decisions become more complex," Calderon says. You have to decide where you want to invest your resources.
Specialists have the wherewithal to develop their expertise and can partner with experts in other areas, he says. "You choose partners that make those investments to be best-in-class, and if they are not doing a good job, you can switch partners at no cost to your business."
But a pure-play manufacturing model also may not be enough. Nearly all EMS companies have delved into design—but not to the extent Flextronics has. The company has completed several strategic acquisitions—Hughes Software Systems, Sheldahl, Avinsoft—to gain expertise in design and components. And none of Flextronics' competitors have ventured as deeply into components. Flextronics' fabrication capabilities, management tells analysts, now include camera module components, flexible printed circuits, antennas and power supplies. They may potentially also include heat sinks, wireless accessories, RF and power amplifier modules and small-form displays. The company also provides silicon design services through a semiconductor operation and has recently enhanced its capabilities through the acquisition of Peripheral Imaging, a designer of contact image sensors, and investments in the fabless semiconductor companies Inphi and inSilica.
Design services and components, the company told analysts, have the potential to increase from an estimated 17 percent and 31 percent of sales and profits, respectively, in 2005 to 25 percent to 30 percent of revenue and 45 percent to 50 percent of profits over time.
But does Flex have designs on the merchant components market? Right now, it's clear that the company's main intention is to use its components capabilities to drive costs out of its vertically integrated services. "Being vertically integrated is strength," insists Flextronics CTO Nicholas Brathwaite. "To be successful in the EMS/ODM space today, a company needs to be able to demonstrate independent ability to impact product cost. In order to do this, it is imperative to drill down into every element that goes into the overall product cost and develop vertical capabilities that a customer can leverage, ultimately reducing product cost."
Analysts aren't betting against Flex when it comes to this new tack. The key, they say, is striking the right balance—somewhere between vertical integration and the classic EMS business. If Flex uses its components capability to drive costs out of its vertical business model, it will have a considerable competitive advantage. "It is providing vertically integrated services only to a narrow customer base," says Matthew Sheerin, EMS analyst at Thomas Weisel. "The key will be knowing when enough is enough."
And Pick points out that Flextronics is stopping just short of complete vertical integration. "It has already told analysts it won't go to market with its own brand. That will keep the OEMs happy."
EMS/ODM MARGINS HIT THE SKIDSindustry averages, 1999-Q1 2004
| EMS/ODM Margins: Rolled-up Averages | 1999 | 2000 | 2001 | 2002 | 2003 | Q1, 2004 |
| SOURCE: iSUPPLI |
||||||
| EMS gross margins | 10.7% | 8.9% | 8.0% | 6.7% | 6.0% | 5.3% |
| ODM gross margins | 15.8% | 12.6% | 13.6% | 12.2% | 10.0% | 7.9% |
| EMS net income margins | 3.7% | 2.0% | 0.4% | -11.0% | -6.0% | 0.4% |
| ODM net income margins | 11.5% | 9.6% | 9.1% | 7.0% | 6.2% | 6.5% |
