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WHY OUTSOURCE

February 2000

"Making Out" / "Outsourcers Rise Again"
By Robert McGarvey

Just a decade ago, outsource manufacturing was a grimy little industry where no-name shops with wallet-thin capitalization’s jumped whenever brand-name OEMs called with overflow manufacturing work.

But feast your eyes on the buffed up and rechristened electronic manufacturing services (EMS) companies that have become the darlings of Wall Street. In fiscal 1999 Solectron, first among the largest contract manufacturers, pulled in $8.4 billion in revenues, along with profits of $293.9 million - enough to command a current market cap of $23 billion. That's more than half again as great as the market caps of far more publicized media favorites such as Apple Computer (market cap, $14.5 billion) and 3Com (market cap, $14.6 billion).

But this is not a one-company category. Just about all of the top contract manufacturers, from Flextronics International to Celestica and Jabil Circuit, are riding high on billions in revenues and burly market caps. "I like all the leaders," says Roger Norberg, an analyst with US Bancorp Piper Jaffray. "This is a great growth industry."

In 1998, the global market for contract manufacturing was estimated to be around $60 billion growing at 20 percent annually. The market is projected to top $150 billion by 2003 - estimates that some say are conservative. The sector's top guns are saying the same thing. "By 2001, to be among the largest contract manufacturers in this business, you'll need $10 billion in annual revenues," says Eugene Polistuk, CEO of Celestica. "Just five years ago, nobody would have thought there would be a $10 billion EMS, but soon that is going to be the minimum to be a Tier 1 company."

Riding the Wave
Why are OEMs rushing to contract out their manufacturing? "We're in the midst of an enormous shift in strategy by OEMs, where they now are embracing a virtual manufacturing strategy because it saves them money," says Jabil's president, Tim Main. "On the low side, when an OEM outsources to us, its savings will be 10 percent. It could be as high as 50 percent if they have been very sloppy."

Gordon adds, "For an OEM, the benefits of outsourced manufacturing are compelling. The OEM gets to concentrate on its core competencies - R&D and marketing - and reduces costs. And it decreases debt because manufacturing is capital-intensive and those investments are shifted to another company's books. The question shouldn't be, Why is this happening? The question should be, Why didn't this happen sooner?"

One reason it didn't happen sooner is "it had a stigma," says Gary Venner, director of consulting at Technology & Business Integrators. OEMs hadn't accepted the notion of putting their labels on products they had never touched, so many were leery about outsource manufacturing.

But relentless downward pressure on pricing forced OEMs to take another look at outsourcing about five years ago, and most of them liked what they saw. "Often you can get higher-quality manufacturing and lower costs by turning to a contract manufacturing solution," says Robert Freid, principal of Contract Manufacturing Consultants, a firm that advises companies seeking outsourcing solutions.

Do the OEMs lose anything by handing off manufacturing to an outside company? Probably not. "There really are few places where manufacturing makes the difference," says Bryan Stolle, CEO of Agile Software, which develops supply-chain management software. "It's all about time to market and pricing."

Accelerating time to market is where the top contract manufacturers shine. These companies have facilities scattered around the world, so time to market is almost instantaneous. In the process, costs inevitably are pared down. "Manufacturing is our business, and we're good at it," says Michael Marks, CEO of Flextronics, a Singapore-incorporated company with administrative headquarters in San Jose, Calif. "OEMs never cared about, never put their top people in, plants - but we do. And we also run our plants at much higher capacity. That's how we can cut costs and deliver quality."

There are, however, some downsides. Competitive product lines often are run in the same EMS plant, and while the contract manufacturers all swear they safeguard customer secrets, the reality is that the essence of cost cutting is pooling resources to maximize capacity utilization. Yet the secrecy issue may not be as significant in practice as one might think. "Many companies have realized their manufacturing was commodity processes, not proprietary," says Freid, "and that's why they have gained more comfort with outsource manufacturing."

"Outsourcing isn't for every OEM," Fried adds, but for many of them, it's just the ticket. One reason the rising tide of outsource manufacturing won't lift all ships is that OEMs want one-stop shopping. "The advantages outsourcers offer are clear and far outweigh any disadvantages," says Evelyn Cronin, an analyst with Dataquest.

Trust Comes First
Of course, all that wild optimism doesn't translate into upbeat prognostications for every EMS company. "I like all the top-tier players - the largest contract manufacturers, but there are 2,000 companies below them, and those companies will face difficulties," says Norberg.

Others estimate the number of EMS companies to be even higher. "I believe 3,000 would be a conservative estimate," says Cronin. Not surprisingly, analysts are anticipating rampant consolidation. "There is not a good future for outsourcing companies with revenues under $1 billion. There may be room for niche players - small companies with sales under $100 million - but it will be tough to stay in the middle and succeed," says Marks.

One reason the rising tide of outsource manufacturing won't lift all ships is that OEMs want one-stop shopping. They would prefer that their EMS providers offer both global reach and a broad range of services, from assistance with product design to shipping to retailers or end-users, says Cronin. Almost by definition, that means massive EMSs. Plus, being amoung the top contract manufacturers implies stability and breadth of resources, which is what it takes to engender trust in large OEMs.

A wave of mergers and acquisitions is also fueling the bigger-is-best trend. In 1998, for instance, Manufacturing Market Insider newsletter logged 68 acquisitions in this category, up 36 percent from 1997. Today, that wave is starting to resemble a tsunami, with ever bigger acquisitions. Last September, for instance, Solectron acquired memory maker Smart Modular Technologies for $2 billion. Earlier in the year, Flextronics absorbed Finland's EMS Kyrel, and Celestica swallowed a smaller contract manufacturer, International Manufacturing Services. "We'll see more acquisitions of smaller competitors by the largest contract manufacturers and more divestitures by OEMs," predicts Jabil's Main. And indeed, Jabil itself has acquired a couple of smaller EMS companies: GET Manufacturing and EFTC Services. "The big contract manufacturers are extending their global footprint and enhancing their service offerings," says Main, "and that's what OEMs are asking for."

As a result, the top contract manufacturers - the big dogs in the category will be fighting over an ever-expanding pool of outsourced manufacturing, while the pups are left to wrangle over the scraps. But will all the big dogs grow and prosper? Industry experts say telling differences are beginning to emerge. "From the outside, all the top OEMs look similar," says Norberg. "But there are important differences among them."

Solectron
As reigning champ in this industry - with FY '99 revenues of $8.4 billion (up from $5.3 billion in '98) - Solectron is a giant; it has 23 manufacturing facilities worldwide and more than 37,000 employees. Entrenched in such low-cost regions as China, Romania and Mexico, Solectron nonetheless ranks as Silicon Valley's fourth-largest employer, with 6,000 workers in the region. Add it up, and "Solectron is the leading [contract manufacturing] provider by any measure: sales, profitability, balance sheet and quality," says Merrill Lynch analyst Jerry Labowitz.

Moving forward, Solectron will emphasize providing OEMs with product design and development services. "An OEM can come to us with a product idea and say, ‘Can you help us design it?'" says Michael Donner, director of corporate communications at the company.

And indeed this strategy makes good financial sense, CFO Susan Wang adds. "There's more value-add in design, and the profit margins are higher," she says. This is a plus because Solectron, like all of the top contract manufacturers, wrestles with slim margins: 3.4 percent, compared to, say, Cisco's 17 percent or Dell's 8.1 percent in recent periods.

Solectron is on a roll now, but it stumbled in mid-1998 when it announced a deal with Ingram Micro to build white-box computers to order for Ingram's customers. The problem, say industry insiders, was that many OEMs considered this a direct competitive challenge and warned Solectron to back off. Nowadays, when asked about the Ingram Micro deal, Solectron executives act as if it never happened - and if it did, it meant nothing. "Ingram had a white-box business, but they deemphasized it," says Wang. "We did provide manufacturing solutions, but we are a outsource manufacturing services company."

It appears that the company took the OEMs' message to heart, however, because Solectron is now adamant that it will not enter the branded marketplace. "We will never put out a product with Solectron's name on it," says Wang.

Celestica
From fiscal 1997 to 1998 (ended December 31), Celestica's revenues soared 62 percent to $3.2 billion. The company maintained that brisk pace in 1999, with $2.3 billion notched in the first half of the year (up 54 percent from the previous year). Net income was also up - a loss of $22.7 million in the first half of '99, compared with a first-half loss of $51 million in '98. "Our investments are paying off," says CEO Eugene Polistuk. "We're growing by 60 percent this year, and two-thirds of that is internal, not due to acquisitions."

How does Celestica differ from its competitors? "We were spun out of IBM in '96. We never were an overflow business," says Polistuk. "We've always had a focus that's compatible with our global OEM customers." Another differentiator, adds Polistuk, is that "we have much more internal technology capability. We have 1,800 degreed engineers on staff. We provide our customers with solutions."

While it's true that its engineering strength positions Celestica to deliver more generously margined front-end design solutions, the company does have an Achilles heel: Over 60 percent of its factory capacity is in North America, which means its global reach is thinner among the largest contract manufacturers. For now, however, that's not a worry, according to Polistuk. He'll expand globally to meet customer demand, and with a recently completed $488 million secondary offering of common stock, the company has the cash. "I'm offered an acquisition deal every week," he says. "but we'll be prudent in our expansion."

Flextronics
If you're looking for a company with momentum, Flextronics has been on fire. From fiscal 1998 to fiscal 1999, the company's revenues increased 54 percent to $1.8 billion at the end of its fiscal year on March 31. And for the six months ended Sept. 24, 1999, Flextronics had revenues of $1.48 billion, up from $868 million in the comparable year-before period.

Why do so many large OEMs - including Philips Electronics (16 percent of Flextronics' revenues), Ericsson (15 percent) and Cisco (11 percent) - turn to Flextronics? "We're more international than any other EMS. Only 23 percent of our operations are in the U.S. We're very large in China and in Brazil. We have 7,000 employees in Hungary," says CEO Marks. While everybody else in the industry talks global manufacturing solutions, according to Marks, Flextronics has "infrastructure in place, especially in China, Brazil, Mexico, Eastern Europe, that nobody else does. We are solidly positioned for growth, and we want Wall Street to understand that."

"Flextronics will be a long-term winner in this industry," predicts Gary Ogden, a one-time director of marketing at Solectron …"It's a very well-run company."

Jabil Circuit
With revenues shooting up 57 percent to $2 billion for the fiscal year ended Aug. 31, 1999, and income up 31 percent to $91.5 million, Jabil, too, has staked out a position in the industry's fast track. With operations in the United States, Scotland, Italy, China, Malaysia and Mexico, Jabil's best days are still ahead, according to Main. "We will continue to move forward with acquisitions," he says.

Going the acquisition route, however, represents a major shift in strategy. Traditionally, Jabil has differentiated itself by ignoring acquisition possibilities and focusing on internally generated growth. However, the company dumped that policy in mid-1998 when it bought a couple of circuit-board plants from Hewlett-Packard and, more recently, when it bought GET Manufacturing (which operated three factories in China) and EFTC Services (a service and repair business).

How big can Jabil get? Stuart Bogard, an analyst with Stephens Inc., projects Jabil's year 2000 revenues will hit $3.2 billion and, better still, its product mix will tilt toward high-growth communications sectors (40-plus percent of revenues). Bogard says he is "bullish" about Jabil.

SCI Systems
Whatever happened to the industry's one-time leader? During the late '90s, SCI led the pack, but according to the CEO of a competitor, "they've stumbled. Their business model has been to exploit low-end manufacturing [with a heavy emphasis on building subassemblies for Hewlett-Packard, Apple and others, but with little assembly of finished product], and there's no growth there and there's no profit." And indeed, SCI's recent financial numbers back up this assessment. While competitors notched double-digit growth in 1999 revenues and profits for the year ended June 30, 1999, SCI reported a drop in revenues to $6.71 billion (from $6.81 billion in '98). Moreover, earnings slipped to $137.8 million (from $145.1 million in the previous year).

Results for first-quarter 2000 look a bit rosier, with sales growing to $1.66 billion (from $1.57 billion in '99) and net income hitting $40.7 million (compared to $30 million in the first quarter of 1999). With 35 facilities in 16 countries, SCI cannot be counted out, but "they have a job of repositioning themselves in front of them," Sherman says.

"Traditionally, SCI always focused on doing huge runs of very little value-add work that generated scant profitability," says Ogden. "They took work other companies, like Solectron, passed on. They need to change that focus and emphasize profitability." If SCI does have a strategy to reverse its fortunes, it's not sharing it - company executives declined to be interviewed by Upside. However, a first-quarter press release might provide a hint: "The company continues its focus on broadening and balancing its product and industry activities on a global basis." It seems as if SCI is tilting more into the manufacture of finished products, but industrywide, SCI's future remains an enigma.

Nipping Pups
As dominant as these large players are, the EMS leaders don't get all the attention. For example, many industry insiders like Sanmina's well-honed expertise in its telecom niche, where it services customers such as Cisco, Nortel, Lucent and Alcaltel. Although its 1999 numbers (revenues of $1.2 billion for its fiscal year ended Oct. 2, 1999, and profits of $121.9 million) place it well below the first five, Sanmina CEO Jure Sola claims the company is ready to break into the top bracket. "We're projecting 50 percent revenue growth for 2000. You cannot tell your customers no, so our challenge is to grow fast enough to meet demand."

Some observers think Sanmina may be well-positioned for growth. "It's not a well-understood company," says Norberg, "but it has all the fundamentals." The company's core strengths are in servicing the higher-end product needs of its telcom customers. Says Sola, "We expect to see much more outsourcing by telcoms, which have outsourced only 10 percent of their work, so the growth potential is high."

Privately held Manufacturers' Services Ltd. (MSL) also piques some interest because, with '98 revenues of $838 million (up 49 percent from 1997), it ranks just below the top tier, and it's notched that ranking in only a few years. Founded in 1994 with funding from Donaldson, Lufkin & Jenrette's Merchant Banking Partners (which now owns 80 percent of the business), MSL will have 1999 revenues of "around $1 billion," says CEO Kevin Melia, though he won't disclose profits. With operations in Asia, Europe and North America, MSL pursues global business. A major obstacle is that "large, public OEMs want to deal with large, public EMSs," says Melia, who adds: "It's nearing the time for us to go down the public path. It would give us more access to capital for expansion." Industry experts say that at its present size, MSL's future is uncertain, so look for it either to go public or get swallowed by a bigger player.

Will the Bubble Burst?
Even as EMS revenues crest ever higher, dark clouds have begun to form. "OEMs are wondering if the contract manufacturers are getting too big for their britches," says Technology Forecaster's Gordon.

Even as EMS revenues crest ever higher, dark clouds have begun to form. "OEMs are wondering if the contract manufacturers are getting too big for their britches," says Technology Forecaster's Gordon.

Adds Sherman, "OEMs are wringing their hands over becoming too dependent on EMSs." For now, though, the competitive pressures that pit multiple EMSs in dogfights for the same chunk of contract work seem to have tempered OEMs' fears. However, industry insiders admit it remains a gnawing worry.

Yet there's not much OEMs could do to reverse the trend even if they wanted to. "A major OEM that doesn't outsource just cannot be competitive on price," Sherman says.

Another fear surrounding EMSs is that as they begin to offer everything from design to aftermarket servicing, they may start to resemble the OEMs of yore, albeit with much smaller margins. "Managing their increased organizational complexity will be a real challenge for the contract manufacturers," says Booz Allen's Jaruzelski.

For their part, EMS executives scoff at the OEM comparison. "If we're inefficient and slow, we're out of business," says Flextronics' Marks. "We'll never look like an OEM of 10 years ago."

The biggest concern for EMSs may well be just their sheer growth. "Manage this business wrong, and it goes bad in a heartbeat," says Piper Jaffray's Norberg. With the big players all bulking up at double-digit rates, the potential for slipping increases. "Managing growth is becoming the issue in the industry," says Sherman.

These quibbles aside, the big news is that this is probably the first chapter in the EMS story. "To me, this trend is only at the beginning. It's just now taking root," says Keith Burgess, global managing partner for Andersen Consulting's business process management practice. "The real trend among OEMs is that outsourcing has become sourcing. This is how they manufacture and, for many newer companies, it will be the only way they know."

That's why Dataquest's Cronin says, "The only curve in front of the EMS industry is up."

Robert McGarvey writes columns for Entrepreneur Magazine and BizTravel.com, as well as feature stories for a variety of magazines.