Survival of the Fittest?

EMS providers adapt to stay alive

Unless you're sleeping or comatose, you must be aware of the rampant morphing of business models in the electronics contract manufacturing industry.

Traditional Electronic Manufacturing Services (EMS) providers now are announcing they are offering full system- design capabilities in many product segments, including mobile phones, camera modules, printers and high-end servers. These Original Design Manufacturing (ODM) initiatives add to EMS providers' existing EMS capabilities and appear to be of critical strategic importance to the future of the EMS industry.

So what's driving the hybrid business models of EMS entities? The answer to that question is actually quite simple: margins.

The Defensive EMS

Over the past year, traditional EMS companies including Flextronics, Sanmina-SCI and Foxconn have undertaken numerous ODM initiatives. The key factor driving this service-offering change can be found in the cliché: "The best defense is a good offense."

Traditional EMS providers derive much of their revenue from procurement services. Thus, much of their value-add is specific to the buying and selling of components.

Over time, the OEM customer count for EMS firms has grown and they have gained a significant amount of buying power, allowing them to negotiate favorable pricing with their component suppliers. As EMS providers developed this competency, they realized they could generate significant profits by capturing the purchase-price variance resulting from the acquisition and sale of components.

However, OEMs have become rather suspicious of the procurement activities of their EMS providers. Furthermore, as iSuppli has reported, a number of large OEMs are institutionalizing "price masking" programs to minimize - or eliminate - the purchase price variance issue noted above. OEMs with price-masking programs include Motorola, Hewlett-Packard and IBM.

In a recent iSuppli survey, six out of fifteen OEMs, i.e. 40 percent, responded that they now are using price- masking programs with their EMS providers.

As a result of these programs, the EMS providers may lose a significant portion of their procurement value-add. Ultimately, the typical EMS provider will suffer margin loss in the range of 4 to 8 percent due to this lost value-add. As Jure Sola, chief executive officer of Sanmina-SCI, recently stated during a conference call, "This industry cannot exist on the margins that exist today."

ODM Divisions to the Rescue

The question for EMS managers then becomes, "How can I drive new margins to my business?" As evidenced by the recent activities in the EMS community, the answer to that question has been design services.

In the last 12 to 14 months, system-design activity among the top EMS companies has proliferated. Flextronics, Foxconn, Celestica, Sanmina-SCI and Elcoteq all have developed or acquired ODM divisions.

Using the Taiwanese ODMs as a benchmark, profit margins in this industry can be modeled in the 8 to 10 percent range for high-volume, low-mix products. This is significantly higher than the margins that most EMS firms typically garner. However, the Taiwanese ODMs have experienced significant margin erosion as the large OEMs use their purchasing power to squeeze cost out of the supply chain.

Another benefit for EMS providers from undertaking ODM initiatives is they can enter into direct competition with the Taiwanese ODMs. Consider the fact that the 10 largest Taiwanese ODMs chalked-up $36.6 billion in top-line revenue during 2003, a 38 percent increase compared to 2002. Thus, it's no secret that the EMS providers have lost OEM spending to the Taiwanese ODMs in a number of manufacturing segments.

Will the ODM play lead to a long-term increase in margins and profitability for the EMS community?

While the jury is still out, the EMS providers have little choice; they are engaging in design activity to survive. It seems that a new round of Darwin's survival of the fittest has just begun.

Adam Pick is a senior analyst in the EMS/ODM Supply Chain service at iSuppli Corp. Contact him at apick@isuppli.com