Electronics Production | July 13, 2009
The Changing EMS Landscape - significant change is coming
In parts 1 and 2 of this series we discussed a number of the changes that are likely to take place in the EMS industry over the next five years. Many of these changes will be driven by a renewed emphasis on the creation of shareholder value in the industry as owners, investors, and equity markets grow increasingly frustrated with the near decade long decline in the value of EMS enterprises.
Some tier one EMS companies have seen their market values decline by more than $10B over time, while some poorly positioned smaller players have fared even worse. Macau based Nam Tai has seen the company’s enterprise value contract from a peak of about $1.4B in early 2005 to just $16M today – with the company occasionally trading on the New York Stock Exchange at a negative enterprise value, indicating that the company is valued by investors at a discount to the actual cash on its balance sheet. Figure 1: Loss of EMS Shareholder Value - Example At some EMS companies, boards of directors are trying to appease shareholders by contemplating bold new strategies to either drive or unlock shareholder value. While among the less fortunate in the industry, bankruptcy judges and conservators are trying to apportion the economic remains of failed EMS strategies. Although the future direction of the EMS industry and its vast cadre of participants is far from certain, industrial history, academic theory, and first hand observations from this active industry participant all provide insights into some of the various paths likely to be taken by EMS providers as they retool strategies in search of shareholder value. Small and Specialized vs. Sizeable and Segmented In part 2 of this series we looked at the past success of tier one EMS providers relative to past leaders in other high growth industries to try to assess the likely direction these firms might take. Recall that noted professor of organizational theory Glenn Carroll generally observes of market leaders that “…these successful organizations become generalists………….which sets the stage for the entry and success of small and highly specialized firms.” Thus the development and expansion of an increasingly specialized group of niche EMS providers will be among one of the most noticeable and impactful changes in the industry over the next five to 10 years. The emergence and rapid growth of these specialized players servicing fairly narrow niche widths within the industry will attract a meaningful share of business from some industry segments such as medical, industrial, and aerospace, where outsourcing has realized lower penetration rates. As these under-penetrated segments seek to outsource more production, the smaller, more narrowly focused EMS providers are likely to draw a proportionally higher share of this new business. This trend of niche players increasing their market share gains in the underpenetrated markets will serve to hold down the incremental margins of the larger and more generalist EMS players who will continue to compete fiercely over larger pieces of less specialized business in core markets such as consumer, communications, and computing. Figure 1: Valuation Multiple of EMS Companies – Specialists vs. Generalists This trend is already evident in the margins and corresponding valuation multiples of the smaller, more specialized EMS companies, which currently garner valuation multiples two to three times that of their larger peers. There are of course numerous benefits to being one of the larger, dominant generalist players in any industry, but when that industry is characterized by exceptionally low margins and primarily price-based competition, the generation of shareholder returns above the market’s average is generally not one of those benefits. Does this suggest that getting more specialized is a possible strategy for one or more of the larger EMS providers? Perhaps - but for larger companies like Celestica, Foxconn, Sanmina-SCI, Jabil, and Flextronics, getting specialized would mean making one of two choices on a continuum ranging from managerially difficult to emotionally distasteful: (1) getting very segmented, or; (2) getting significantly smaller. Several of the largest EMS players have embraced varying degrees of segmentation/specialization with differing levels of success on both customer penetration and margin expansion. But creating the degree of resource specialization, internal focus, and service level of smaller, truly niche players inherently reduces some of the operating efficiencies that these larger companies rely on to compete – a problem that Joseph Heller would truly appreciate. This leaves only the prospect of getting smaller, which is a strategy that for many reasons is rarely embarked upon. Sanmina-SCI made a significant step in this direction not too long ago, divesting three billion dollars worth of zero margin computer business in a move that likely saved the company. But up until now strategically getting smaller has been a fairly unique case. Vertically Integrated vs. Sum of the Parts – Creating Shareholder Value For some of the larger EMS players, one path towards getting smaller could be the systematic breaking up of the company into vertical businesses, smaller industry focused niche EMS companies, procurement services companies, or some combination thereof. Currently irrational public markets notwithstanding, there are a number of interesting businesses operated within EMS companies today that could fetch reasonable prices in the market – especially when viewed in the light of the extremely low valuation multiples of their current EMS parent. Every few years one of the major Wall Street analysts will publish his or her “Sum of the Parts” valuation models on Sanmina or Flextronics or Foxconn. These models invariably indicate that large vertically integrated EMS companies should be surgically carved up into their various constituent components consisting of numerous product and services companies. Many would argue, for example, that Sanmina’s medical and industrial EMS segments have a market value far greater than the current total market capitalization of the company. Spinning these businesses off along with several other businesses (including a chassis business, a PCB and backplanes business, a NAS storage ODM business, a cable and harness business, etc.) would allow each of these business to be recognized and valued separately in the public (or private) markets and would likely drive a significant increase in shareholder value. But these “Sum of the Parts” models rarely consider the revenue synergies between the various businesses and the potential loss of interrelated sales in each individual business. But the potential dismantling of an EMS company’s vertical capabilities which were painstakingly assembled over many years presents both significant administrative challenges and simultaneously calls into question the validity of the initial strategy relative to shareholder value creation. It is an even money bet however, that should the next economic upturn not bring with it a truly meaningful increase in the valuation multiples of publicly traded EMS companies, it is extremely likely that at least one of the top five global EMS players will undertake this bold move and try to drive shareholder value by unlocking the value currently hidden amongst the sum of its various parts. In-sourcing vs. Outsourcing – Has the pendulum changed direction? In writing this article, I was struck by the fact that my spell checker recognizes that “outsourcing” is a common word but did not recognize the term “insourcing” unless I insert the Microsoft rule confounding hyphen. Yet among a number of Riverwood Solutions’ larger clients and prospective clients, the topic of in-sourcing is very much in vogue. Several larger companies that drive significant supply chain spend and manufacturing volumes are beginning to question the fundamental economics of outsourcing manufacturing. Clearly the outsourcing model works exceptionally well for small to mid-sized companies that produce cyclical products in volumes below some minimally efficient capacity increment. But what about those companies that spend billions a year on EMS services and drive world class component pricing that can only be matched by their EMS provider by way of a purchasing assignment agreement? Nokia sent some pretty big ripples through the EMS industry late last year and early this year as it in-sourced considerable product volumes from EMS suppliers in order to fully utilize its captive manufacturing capacity – possibly sounding the death knell for one of its major European EMS providers. Other major OEMs talking about or considering some level of insourcing encompass a wide range of products and industries from consumer electronics to industrial products. Although it is too early to say whether the increasing talk of in-sourcing foretells a secular inflection point for the EMS industry, it is interesting to note anecdotally that two of the worlds largest and most successful tech companies, Nokia and Intel, have been unwavering in their strategies of keeping captive the manufacturing of their core products. An argument can be made that if an industry giant such as Nokia were to outsource 100% of its production, that process would likely create far more economic benefit for its competitors than would be realized by the company itself. The massive influx of volume into the EMS system would incrementally drive down fixed costs and improve the purchasing power of the EMS providers – and these benefits would certainly accrue to Nokia’s outsourced competitors like Motorola and SEMC. The increasing level of conversation around in-sourcing, whether theoretical or otherwise, is likely driven in part by the fairly high level of dissatisfaction that OEMs feel with their EMS providers. In Riverwood Solutions’ Q1, 2009 survey of electronics OEM representing more than $100B in total supply chain spend, only 18.8% of respondents reported being satisfied with the overall value that they receive from their EMS providers. More than 40% of respondents had near term plans to hire additional operations staff in remote locations to help manage their outsourced relationships. This broad dissatisfaction with EMS providers, the increasing cost of managing these relationships, and the new found chatter about in-sourcing all lead me to believe that we will see some level of movement in this direction over the next five years. It is not unlikely that we may see one of the world’s 20 largest OEM users of EMS services partially reverse course over the next five years and opt to in-source significant aspects of its manufacturing. CDM & ODM vs. OEM – Redrawing the line between innovation and design Clearly one of the most pervasive trends of the last seven to 10 years has been the broad move in many electronics related industries to embrace the Original Design Manufacturer (ODM) model for product design. And although I fully understand some of the economics driving this explosive trend, the strategy implications and structural ramifications fly in the face of some of the basic tenets of the outsourcing model. Years ago, as an EMS executive in a far less mature EMS industry, I remember quite clearly elaborating the arguments of core competencies, specialization, and management focus to explain in logical terms some of the benefits of outsourcing manufacturing to a company that specializes only in manufacturing. I would often talk about the complexities of marketing, product development, and manufacturing – and how difficult it must be for management to devote meaningful attention to these vastly different disciplines. The quote I often used in trying to sell reluctant, old school OEMs on the benefits of the EMS model went something like this: “Manufacturing excellence does not need to be a core competence, unless manufacturing excellence is your core product.” Yet fast forward to 2009 and the fastest growing segment in the outsourcing world are those companies known as ODMs that will not only design your entire product for you, but will manufacture it as well. Now if only these ODMs would add outsourced services around marketing and branding, we would be able to outsource the entire OEM enterprise. This move towards the ODM model over the past decade has been so swift, and so pronounced in some sectors and within some OEM companies, that the momentum is certain to change course to some extent over the next five years. Since about 2003, the ODM space has experienced a growth rate about twice that of the traditional EMS players. But many a once storied OEM has begun to realize the errors of their over-aggressive cost cutting ways, and have become concerned about the impact of this trend on their company’s long term prospects. In less than 10 years, many OEMs have evolved from fully captive product development, to outsourcing some specific design work on contract, to outsourcing almost their entire product roadmap to fast moving and cost effective ODMs in Taiwan and now China. Having hollowed out considerable portions of their internal product develop capabilities, some OEMs are now realizing that they are highly dependent on arm’s length transactions with ODMs for not only their product designs, but for an increasing portion of their product innovation and differentiation. Given that these same ODMs are readily available to, or already working on, product innovation for the OEM’s top competitors, the prospects for truly meaningful product differentiation based on design innovation seems increasingly slim. This is not to suggest that the ODM model is doomed and that Quanta, Compal, Wistron, Lite-On, et.al. will soon disappear. Clearly the ODM model is here to stay. In certain industries, such as laptops and motherboards, the basic structure of the industry is now built around these massive Taiwanese ODMs, providing so much inertia to the ODM model in these industries that it simply cannot be reversed. But the broad-based and rapid rate of increasing penetration of the ODM model across virtually everything electronic has just about run its course. Recognizing that the power of a brand is only sustainable as long as there are truly innovative, and more importantly differentiated products behind the brand, OEMs en masse will start re-evaluating the degree to which they use ODMs on core products. This is not to say that OEMs will abandon the ODM and CDM models. But there will be a pronounced shift in the deployment of key resources by OEMs in the areas of product conceptualization, product architecture, and functional master design towards internalization, with ODMs being relegated to the more laborious and less strategic tasks of “packaging” the designs. The EMS industry will undoubtedly undergo a number of significant changes over the next five plus years as the industry continues to mature and consolidate. Taking a few lessons from industrial history may provide us a view of some of the changes in the competitive landscape that we are likely to see in the EMS space. But the sheer size of the industry ($280B) and the breadth of industries that it serves clearly make foretelling its future a fool’s errand - which I have now dutifully undertaken. The only real certainty that I hold regarding the future of the EMS industry is that it will look different tomorrow than it does today. Author: Ron Keith, Chief Operating Officer, Riverwood Solutions ------ This article is part of a series: Part 1: The Changing EMS Landscape Part 2: The Changing EMS Landscape - Over the next 5 years