Ron Keith, Riverwood Solutions Electronics Production | April 06, 2009
The Changing EMS Landscape
Many of the trends impacting EMS providers and OEMs over the past five years will continue, but some brand new trends will clearly emerge.
By: Ron Keith Chief Operating Officer Riverwood Solutions A tremendous number of things have changed in the last five years: world markets, geopolitical landscapes, global economies and global climates just to name a few. Just five short years ago, EMS providers and their OEM clients were climbing their way out of the “tech wreck” that was the aftermath of the bursting of the 2000 tech bubble. EMS providers were slowly working margins back up and settling into operating in what was by then a reasonably mature and well established global industry with sales in excess of $100 billion. OEMs were accelerating their outsourcing activities in pursuit of cost reductions and improved asset velocity, although perfecting their EMS relationships was continuing to prove elusive. Pundits and protectionists in the U.S. and Europe, lacking both clarity and comprehension, continued to vacillate in their views on the impact of the outsourcing of electronics manufacturing on their country’s industrial and economic base. Were these the high paying manufacturing jobs western countries needed to defend, or was this simply another step in the long procession towards a knowledge-based and skills-based economy? This question seems to have been answered by the infinite wisdom of the market’s invisible hand as evidenced by the evolution of the pricing of EMS services and the valuing of EMS companies. As the EMS industry has reached a level of maturity over the past several years, the process of outsourcing manufacturing and the process technologies employed by the outsourcing providers have become quite ubiquitous. As many of the world’s largest OEMs exited manufacturing, they abandoned their semi-custom manufacturing processes and their long held beliefs that manufacturing was part of their competitive advantage. The increased adoption of outsourcing and decoupling of product companies from the factory floor has quickly changed the perception of manufacturing at most electronics OEMs. What was once a core competency and a source of competitive differentiation is now largely viewed as a commodity, to be purchased and managed as such with the underlying assumption that all manufacturing services are basically equivalent. Figure 1: Long Term Trended EMS Industry Margins EMS Providers Respond to Pricing Commoditization This increased commoditization of pricing of the services offered by EMS providers has created fierce pricing competition among the larger players. Over the past decade, operating margins, as shown in green in Figure 1, have declined by two thirds while industry revenue has increased three fold. In just the last four years, gross margins are off by 86 bps or 14%, while operating margins are off by 56 bps or 20% (as shown in Figure 2.) With this move towards a commoditization of manufacturing services pricing, ex-factory price became the primary competitive factor and primary determinant for awarding much of the EMS business in many different sectors. In this increasingly price competitive environment most EMS providers found it difficult to distinguish themselves from their competition or to sell OEMs on the incremental value of “superior service” that many touted in an effort to garner slightly higher margins. Figure 2: EMS Industry Margins 2005 to Present Many EMS providers thus made substantive attempts to truly differentiate themselves and create unique market positions based upon the services they provide. There have been a couple of divergent responses by EMS providers in order to create this differentiation – or a perception of differentiation. The two most predominate paths chosen have been either differentiation through specialization, or through some type of vertical integration. Figure 3: Top EMS Industry Players and Their Total Revenue 2003 & 2008 Specialization of Focus The first path of differentiation – specialization - allows EMS providers to set themselves apart by focusing services on a specialized field of production or industry segment niche. These companies boost the perception of their value proposition by avoiding the attempt to be all things to all OEMs. Their specialization is usually focused on working with a select group of companies that are related through product technology, through end markets, or through similar production characteristics. This enables the EMS provider to develop a broader understanding of the technology, its technical challenges and capabilities; or develop a greater expertise around the characteristics of how a particular market segment behaves - or both. The perception normally follows that this greater technical competence and/or market savvy honed through specialization yields a better supplier, hence the greater ability to both sell and explain the value differentiation relative to purely commoditized EMS pricing. By way of a technology example, take RF (Radio Frequency) products. Manufacturing RF products requires specialized technology, specialized components, specialized testing, etc. Maintaining a relatively narrow focus on RF products allows certain niche EMS providers to develop a deep set of skills and expertise around the technical challenges involved. They can then apply this expertise to a number of different RF products, which includes wireless modems and routers, blue tooth headsets, GPS devices, and an array of other products that require fundamental RF communications technology. Some of the smaller EMS providers that have carved out a strong niche in the RF area include Tropical, Princeton, HQ, Labarge and to a lesser extent IMI. Medical products are another area where some EMS companies have either focused all of their efforts, or minimally have established separate divisions or groups to focus on this area. Medical devices manufacturing is a somewhat specialized market requiring various approvals, specialized certifications, and accreditations for the facilities in which the devices are produced. EMS providers who develop a specialized technical expertise around these markets and their unique requirements can realize some degree of pricing power for their service offering due to the unique and idiosyncratic requirements pertinent to those markets and important to the OEM’s. Figure 3: One View of Industry Segmentation/Specialization, Courtesy of Plexus At the risk of over-generalizing and thus over-simplifying, EMS providers that have chosen one of the various paths of specialization include medical device specialists IBS, Ventrex, Accellent, and Veridiam. High product mix specialists include such players as Plexus, Benchmark, Zollner, PartnerTech, SMTC, Asteel-Flash and Kimball. Other EMS companies making significant niche investments include Nam Tai in displays and DCA processes, Fabrinet in Optical and Photonics, Elcoteq in consumer mobile, and industry giant Jabil in automotive, just to name a few. These companies have designed their own somewhat unique value propositions by combining the quality of specialization with the cost effectiveness of the consolidation of volume principal originally inherent in the EMS model. EMS companies employing some form of specialization strategy tend to have gross margins ranging from 50 bps to as much as 600 bps greater than their more generalist competitors. Vertical Integration & Expanded Services On a different path to combat pricing commoditization - vertical integration - EMS companies set themselves apart by the addition of related, higher margin vertical services. The basic concept behind this strategy is twofold: (1) that by controlling more of the supply chain, the EMS provider will be more responsive in everything from initial time to market to controlling ongoing product lead times; and (2) that the elimination of external transaction costs will allow the EMS provider to be cost competitive while still earning higher margins. So whether it’s through additional vertical manufacturing services such as fabs, plastics, power supplies and enclosures, or through additional pre-manufacturing and post-manufacturing services such as ODM design or outbound logistics, the more services that are internalized, the greater the elimination of external processing and thus the fewer external transaction costs to be incurred. This makes the vertical integration model attractive to many OEMs while providing additional profit opportunity for the EMS provider. These additional services they provide allow more room for differentiation and generally allow for higher margins than the core commoditized portion of their service offering – provided that EMS providers can hold the line on these services and resist OEM pressures to commoditize the entire supply chain. "71% of Electronics OEMs surveyed said that vertical integration and a broad service offering was important to them in selecting an EMS provider". Source: Riverwood Solutions Q1, 2009 OEM Survey. EMS companies that have embarked upon fairly significant vertical integration strategies as the primary means of combating eroding pricing power include: Foxconn, Jabil, Flextronics and Sanmina-SCI. The jury is still out on the efficacy of this strategy from the perspective of the EMS’ shareholder, as the strategy has yet to demonstrate its ability to reduce the slide in EMS margins, let alone actually allow for profit margin expansion. EMS Industry Consolidation – Different Paths to Bigger Another hallmark of the EMS industry over the last five years has been the continuation and perhaps acceleration of the consolidation of the industry. This consolidation, which is continuing to be a major theme, takes three primary forms: (1)Acquisition of competing EMS firms. Examples of this over the past five years include Flextronics’ $3.6 billion acquisition of Solectron, Asteel’s acquisition of Flash Electronics, IMI’s acquisition of Speedy-Tech, Benchmark’s acquisition of Pemstar, and PartnerTech’s acquisition of Hansatech. (2)Acquisition of vertical service offering. Examples include Jabil’s acquisition of Green Point, Flextronics Acquisition of IDW, and Scanfil’s acquisition of Hangzhou Fuda Stamping. (3) Acquisition of customers’ manufacturing assets. Transactions of this nature over the past five years include Elcoteq’s acquisition of Philips’ flat panel TV manufacturing, Flextronics’ acquisition of various Nortel plants, and Celestica’s acquisition of Powerwave’s facilities in the Philippines. Although the rate of transaction-related consolidation has slowed dramatically with the collapse of the global equity and debt markets, 2009 should witness a relatively new form of EMS industry consolidation in the form of bankruptcies and forced liquidations. Many tier two, three and four players, especially in Europe, are carrying unsustainable and unserviceable levels of debt on their balance sheet at a time when the industry’s fixed capital utilization and margins are both declining. Excessive debt in a high fixed-cost business characterized by commodity-type margins is a recipe for forced liquidation in a world suffering from a severe credit crunch. Riverwood Solutions expects to see no fewer than 11 smaller European EMS companies go bankrupt in 2009, along with seven U.S. providers of various sizes and more than three dozen smaller shops in Asia. But as world financial markets begin to recover in 2010, we should see a dramatic resurgence in acquisition activity among EMS players far and wide. Manufacturing Migration to Low Cost Regions The last big trend in the EMS industry in recent years has been an acceleration of the transfer of production to low cost manufacturing countries, especially in Asia. This acceleration has taken manufacturing from high cost regions in the West to lower cost regions, which has also been evidenced by an acceleration of EMS companies’ investment profile in lower cost regions. Plexus’ recent investment in Romania, Elcoteq’s investment in Mexico, and Asteel’s purchase of a primarily Asia-based EMS company all speak to the accelerated trend towards lower cost manufacturing facilities driven by customer expectations for cost reductions. Increasingly over the past five years, EMS companies have trended away from investing in virtually any production facilities in the West – shutting down more than 110 factories in the U.S., Canada and Western Europe over that period. The move to low cost regions, especially China, has been particularly pronounced over the past few years, initially driven aggressively by U.S. OEMs and quickly followed by many mid-sized European OEMs. In 2003, the entire Asia region accounted for about 38.7% of all production for the EMS industry, while Europe accounted for just 6.7%. By 2007, China alone accounted for more than 46% of all EMS industry production, while European production appears to have peaked in 2007 at just over 10% of industry output. And although this massive move of production has been more pronounced among larger, generalist EMS providers, even smaller niche players have accelerated investments in lower cost regions – creating a bit of protectionist sentiment in a number of western countries, most notably the U.S., France and Germany. So what does the next five years hold in store for the EMS industry and their OEM clients? This will be the topic of my next article on evertiq, so stay tuned. www.rwsops.com Riverwood Solutions is an innovator of managed supply chain services.
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