Battle of the Super Giants
OEM Services: September 27, 1999
electronicnews.com
Scale, successful acquisitions are everything in the new order
By Joel McCormick
Heading into the new century, tier-one contract electronics manufacturers
(CEMs) are looking at scaling up to three times their current size, while
mid-market players choose between growing fast or shrinking away.
The big challenge for ambitious players will be digesting acquisitions now
occurring at a ferocious pace--and avoiding hiccups supplying their OEM
customers while the wrinkles are being worked out.
CEMs are projected to top $100 billion in worldwide business this year and are
on course to hit $178 billion by 2001. Contractors, who now account for an
estimated 17 percent of electronics production, should swallow up to 22 percent
or 23 percent of it by 2000, said Charles Mullen, director of research at
Technology Forecasters Inc., Alameda, Calif.
Dig into the numbers and you see who's getting the bulk of business. While
contract revenues are growing industry-wide at an average 22 percent, several
top-tier players are increasing their sales by 40 percent or better. Solectron
Corp., Milpitas, Calif., this month reported fiscal year 1999 revenue growth of
58.9 percent, while Jabil Circuit Inc., St. Petersburg, Fla., reported fiscal year
1999 growth of 57 percent.
Shrinking product margins, combined with the massive investments that top
CEMs are putting into acquisitions and new plants, explain why building volume
is so crucial. Margins that just a few years ago were 5 percent to 7 percent are
now at around the 3 percent level, Mullen says.
More than ever, success is defined by high volumes, total utilization of assets,
near-zero inventories and corner-to-corner world geographic spread, which
means constant expansion and dense layers of IT to precision manage it all.
Success today also is defined by a capacity to integrate acquisitions quickly. In
October 1996, when Onex Inc. took over Toronto -based Celestica Inc. from IBM
Canada Ltd., the CEM had one plant and 2,500 employees. Now three years
later, Celestica has 15,000 employees and 25 design and manufacturing sites in
the Americas, Europe and Asia.
Restructuring is speeding up. In 1997, there were 50 mergers, 67 in 1998--and
this year, industry analysts predict mergers to top 100. CEMs are also
becoming more vertical, aggressively stretching out from their traditional
manufacturing space and acquiring companies that give them new value-added
opportunities in design at one end and distribution at the other. As one analyst
put it, reacting to this month's announcement of Solectron's $2 billion plan to
buy SMART Modular Technologies Inc., "That's a design story."
First, PC makers took to the fabless model pioneered by chipmakers. Now,
old-guard telecom equipment makers are falling into a pattern set by young
OEMs like Cisco Systems Inc. and 3Com Corp., which never owned many
plants to begin with.
"Ericcson led the pack in Europe," said Joe Regan, vice president for sales at
Solectron. "Now Nortel is shedding some of its manufacturing."
The new industrial model could no longer be avoided, he said. "Now a number of
companies point to Cisco and say, 'If they were successful with that model, we
ought to be.'"
In fact, telecom equipment OEMs are driving outsourcing trends these days.
Tier-one player Flextronics International Ltd., San Jose, now says over half its
revenues derive from networking and telecom OEMs.
"This has been enhanced with the recent acquisition of Ericsson's GSM
infrastructure factory in Sweden and the acquisition of [CEM] Kyrel in Finland," a
Flextronics source said.
With more companies shedding production faster, the top-three CEMs--which
last year were in the $3 billion to $6 billion-plus sales range--should graduate to
$10 billion-plus companies within the next 24 months. The stakes are getting so
high that mid-tier companies will have to merge to achieve the required scale or
drop out of the major league, Tech Forecasters' Mullen said.
"The industry is coming apart at the middle," he declared. Mullen said Angleton,
Texas-based Benchmark Electronics Inc. clearly knew the stakes when it set
out to acquire Huntsville, Ala.-based Avex Electronics Inc.--in earlier days,
America's second largest contract after SCI Systems Inc., Huntsville, Ala.
That move, called very prudent by David Foropoulos of Louisville, Ky.-based
brokerage David Hilliard, now gives Benchmark a combined sales base of $1.4
billion--almost exactly matching the revenue of Jabil, ranked 5th in the 1998
CEM league table.
With the emergence of super giants, breaking the $1 billion sales barrier won't
qualify CEMs for tier-one status anymore, contends Eugene Polistuk, president
and chief executive officer of third-ranked CEM Celestica. In the new industrial
order, he said, only $10 billion companies will qualify. Polistuk also declared
dual sourcing to be an outdated model.
"Most of our work is done on an exclusive basis now," Polistuk said.
Given the global demands of OEMs, single sourcing would require mid-tier
players to get bigger fast or drop out of play. But David Hilliard's Foropoulos
disagrees with the all-or-nothing scenario. "You'll have some product lines like
that but it really depends on the line," he said, pointing to Hewlett-Packard Co.'s
Vectra line that both SCI and Celestica make.
OEMs now are meshing with CEMs in partnerships that look like indissoluble
marriages. Relationships that began over machine shop parts orders are getting
complicated, with contractors managing supply chains from the edges of design
right to the end user's door--with after-sales support thrown in.
Given this deepening dependence--with contracts now counted in years--is it
conceivable OEMs would ever seek an equity stake in their CEMs to retain a
modicum of leverage?
"I don't foresee that kind of relationship," said Andrew Huang of Bear, Stearns &
Co. Inc., New York. "The bottom line is that the OEMs are trying to strip
themselves of their manufacturing so they'll remain separate entities."
Tech Forecasters' Mullen said he has never seen an OEM successfully retake
manufacturing it has given up to CEMs. But Foropoulos said companies aren't
just farming their products out anymore anyway--they're doing their due diligence
for long-term partnerships. "OEMs have as much leverage as they want right
now. They can place their product somewhere else, maybe not at the drop of a
hat, but they can do it.
"The contract manufacturers I know have no intention of building their own
product to compete with OEMs," he said. "They see themselves as the service
components in the supply chain."
Foropoulos said OEMs now see themselves as technology marketing
companies, not manufacturers. And if any needed convincing, Asia's economic
meltdown probably did the trick. "When you have bricks and mortar and you're
building three products in a facility and that facility gets soft like we saw in the
second half of last year in Southeast Asia, you're killed by the overheads."
Result: OEMs think fast about how to turn fixed costs into variable costs.
The OEMs' deepening dependence on CEMs goes beyond mere manufacturing.
"We have better buying power now," Celestica's Polistuk said. Better equipment,
too: "When I look at IT deployment among OEMs, I can see they have
underinvested again and again--because it isn't a core competency."
But partnerships showed strains long before anyone contemplated meshing
logistics networks. Industry executives remember how Acer Inc.'s partnership
with Dallas-based Texas Instruments Inc. (TI) went awry over TI's TravelMate
notebook. Not long after Taiwan's premier PC maker was signed to handle
production of it, Acer came out with a lower priced lookalike that, in effect,
competed with TI's TravelMate, said Chay Yee Meng, chief financial officer of
Singapore-based NatSteel Electronics Ltd. (NEL).
TI ended up selling off its notebook business to Acer. Chay--like his boss, NEL
CEO Chester Lin--is a former SCI executive. And he sees the episode as a
caution against CEMs adopting the ODM, or original device manufacturer,
model. For one thing, he said, contractors posing a competitive threat won't get
new-level technology to work on.
That's one argument. But Taipei-based Acer reports that contract work on
outside OEM orders for PCs and peripherals is exploding. OEM- and Acer-brand
production volumes until 1998 were pretty well split 50-50, said Lo Jen Yin of the
company's corporate communications department. "As of the first half of 1999
our OEM/Brand ratio is 70:30 due to the high growth of our OEM business. In
the short term, we will hold steady with this ratio," she said. "For the long term,
Acer's goal is to seek a 50-50 balance."
Meanwhile, CEMs keep acquiring. SCI in May announced that it had completed
its takeover of HP's VeriFone Inc.'s production plant near Shanghai, where SCI
will continue making VeriFone products as part of a multi-year agreement. In
August, SCI agreed to take over a Nortel Networks Corp.-owned printed circuit
operation in Ontario, coupling that, too, with a multi-year supply deal.
Contract manufacturers can usually cut nice deals with OEMs, equity analyst
Foropoulos said, because soft selling on the plant side usually leads to soft
pricing on the product side. But SCI's Nortel deal, done right under the nose of
Ontario resident Celestica, doesn't cut any ice with Polistuk. "So they bought a
unionized plant in Ontario--good luck," sniffed the CEO.
Some CEMs are now moving aggressively into distribution and more acquisitions
are likely to tilt in that direction in the future. NEL's Chay said his company is a
pioneer, having acquired three distributors last November. Once NEL digests the
acquisitions and establishes wrinkle-free channels across Asia, the plan is to
extend the distribution network into other regions.
NEL, a unit of Singapore's huge NatSteel industrial conglomerate, is riding high
at the moment. Last month, it announced first-half 1999 revenues of 1.23 billion
Singapore dollars ($726 million at current exchange rates) - a 77 percent
increase on the year earlier.
Solectron has also been focusing big-time on distribution. With media reports
calling it an alliance between the world's largest CEM and PC wholesaler,
Solectron last May began producing branded and unbranded PCs for Ingram
Micro Inc., Santa Ana, Calif. The project, fully ramped up, will see 10 million
PCs pumped out of 11 plants, annually.
At the launch, Fred Forsyth, president of Solectron's Systems Engineering and
Services unit, predicted lower inventory costs for OEMs and faster delivery to
end users--48 hours from build order to delivery.
Solectron also announced fiscal year 1999 revenues of $8.4 billion, displacing
SCI as the world's top CEM. The company now says it's on track for fiscal year
2000 revenue in the $13 billion range.
Taking control of the supply chain is all about cutting layers and churn, said
NEL's Chay. "We see a scenario where a customer designs a product, passes it
to NatSteel and NatSteel builds it and gets it to the market directly." The CFO
sees the day when it will be commonplace for contractors to provide OEMs with
their own business forecasts so they'll know what to order.
Celestica's Polistuk argues owning channels may be the way for low-end PC
distribution, but not necessarily for high-end producers.
"Some companies have 50 percent of their business in PCs - we have 10
percent to 20 percent," Polistuk said. That said, Celestica secured more
distribution muscle acquiring D2D (design to distribution), Europe's largest CEM,
and International Manufacturing Services (IMS), one of Asia's largest
contractors.
The old OEM model, where assorted sins could be hidden away in gross
margins of 40 percent, is dead, said Polistuk, who, like his Solectron
counterpart Koichi Nishimura, is an IBM alum. "Our business is low margin,
totally public and visible--so you tend to be faster, more responsive and more
focused."
He predicted 75 percent of all electronics manufacturing will be handled by CEM
hands sooner rather than later. But it will take big hands, not players in the
subbillion- or even billion-dollar arena, he said. "They won't have the scale," he
said. "How many players can spend $32 million on new IT infrastructure as we're
doing?"
Polistuk doesn't wait for an answer. "Scale is redefining everything."
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