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Targeting Design

Many electronics manufacturing service providers are beefing up their design service offerings in an effort to enhance their value to OEMs and fatten their profit margins.

By James Carbone -- Purchasing, 10/21/2004 2:00:00 AM

While revenue growth in the electronics manufacturing services (EMS) industry has been sluggish over the last two years, analysts and EMS providers expect strong growth to return.

The years of 20% annual growth may be over, but most EMS providers believe that double-digit revenue increases are likely. They say the outsourcing trend shows no signs of letting up and the amount of outsourced electronics manufacturing is still relatively small, about 20-25% by most estimates. That means there is room for growth as medical equipment, industrial control and automotive systems OEMs outsource more. In addition, shipments of computers and cell phones—which have been the mainstays of the EMS industry—are expected to increase.

"The EMS industry is growing," says Eric Miscoll, chief operating officer for industry researcher and consultant Technology Forecasters. "The first half of the year has been good. We are entering a phase of cautious optimism. Consumer equipment orders are increasing. We expect high single digit to lower teens percentage growth for 2004," he says.

Revenue increases will be welcome news to the EMS industry. Sales revenue of the top 50 EMS providers in 2003 grew only about 3% to $68 billion in 2003, according to Reed Business Research's annual survey of the top EMS providers. The meager sales growth in 2003 followed a year in which revenue for the top 50 declined 10%.

For the entire EMS industry, revenue is forecast to grow from about $98 billion in 2003 to $115 billion in 2004 and to $163 billion in 2008, according to market researcher iSuppli. Some EMS providers will outpace that growth rate by offering a better value proposition to OEM customers by enhancing their design offerings. In fact, some of the larger EMS providers are taking a close look at the business model of original design manufacturers (ODM).

An EMS provider builds a product for an OEM based on the OEM's design. An ODM will design a product, build it for multiple OEMs and ship it to the OEMs' customers. The ODM model is often used for lower-end cell phones and computers, but may be used to build more complex products in the future.

One company that offers ODM services is Flextronics, the largest EMS company. Flex has about 6,000 design engineers to support its ODM business and other design services, says Robert Dykes, president systems group and chief financial officer. "Our ODM business is an important way we will create margin expansion," says the Flex CFO.

Margin expansion interests EMS providers because they operate on razor-thin profit margins. Net margins are only in the 2% vicinity for the EMS industry, according to Technology Forecasters. Net margins for ODMs are about 6%.

That's appealing to EMS providers who are looking at the ODM model. In addition, the ODM growth rate is expected to double the growth rate of the EMS industry in the next several years. The ODM market will grow from $61.4 billion in 2003 to $144 billion in 2008, according to market researcher iSuppli.

The lines blur

Because of that growth, more EMS providers will offer ODM services and will likely adopt an electronics outsourcing model that blends the strengths of the EMS and ODM models.

"Our view is that the line between EMS and ODM is blurring," says Miscoll. "The industries are converging. There will be a hybrid model that develops in which companies will have to offer both EMS and ODM services." The model has been used in Taiwan, which is home to many ODMs, many of which have been willing to do work on an ODM or EMS basis.

"You could come to them to leverage their design or bring your design to them," says Miscoll. "They have manufacturing operations you could use. The EMS industry has been slow to recognize this convergence and adopt it. There is interest in both models, but our view is that the market for EMS is greater and ODM is more limited in the long term," says Miscoll.

EMS will remain the dominant model because certain equipment, which is more complex and customized, probably won't be handled on an ODM basis.

"Wireless handsets lend themselves to an ODM model, but infrastructure equipment to run handsets doesn't," says Miscoll. "Notebook computers, PCs and peripherals and consumer equipment are suited to the ODM model, but larger, more customized products, lower volume, and higher mix are not." The decision to use an ODM or an EMS provider often hinges on how much intellectual property (IP) is in-volved in the product.

"A highly commoditized product where I can search the Internet and get 85% of the design and then hire two electrical engineers to finish it is something for the ODM model," says Kevin Sachs, vice president of strategic marketing for EMS provider Solectron in San Jose, Calif. A PC would be an example. "If you look at PC motherboards, for anyone on the Wintel standard, the motherboard design is out there," says Sachs.

"At the other end of the spectrum you will have products like Cisco's latest router where the IP involved is in-credibly valuable and cutting edge," he says. Cisco would design the product and outsource the production of it to an EMS provider.

Sachs says the number of products that would fit into the classic ODM model is relatively limited. "Certain cell phones are commodity products and fit in the ODM model, but others are not," he says. "Nokia and Samsung would dispute that their cell phones are commodity products."

"Many cell phone companies view their cell phones as being unique and having some IP associated with them. And they pride themselves in doing their own design work," Sachs adds. "We may work with them on a piece of the design, but the core elements they are going to own."

Feeling conflicted

For lower end phones, some companies want to outsource them to ODMs, but they have mixed feelings about doing so. The ODM model is attractive because the OEM doesn't have to invest any revenue or resources in development of a new low-end phone. "At the same time, the OEM realizes it is helping a potential competitor if it buys that product from a classic ODM," says Sachs. A classic ODM sells the same phone to multiple OEMs who market the product under their own brand names.

That's one reason why OEMs would prefer to use an EMS provider who has ODM services, according to Sachs.

"We have customers who rely on us to do the full product design, which is what an ODM does. The difference is, we say we are not going to retain the IP and compete with the OEM," says Sachs. "It's an important distinction and it's a line we are not going to cross. We believe if we start to compete with our customers, it poses a significant risk to our overall business model."

Sachs calls the emerging model "life cycle design manufacturing" or "collaborative design manufacturing". "It refers to the fact that up front, when we are designing a product, it is collaborative with the OEM to meet their specific requirements and only theirs."

Dan Shea, chief technology officer for Toronto-based EMS provider Celestica says demand for ODM services by OEMs is a significant trend in the EMS industry. "It is happening more in 2004 more than in the past. It has momentum."

In fact, he says having ODM services is a condition that many OEMs re-quire of their EMS partners. "If you don't have some form of ODM capability, then your chances of being part of an OEM's preferred supplier list are much less. You don't have to be an ODM, but you have ODM capability," he says.

Motorola is one OEM that is following the trend of EMS providers to offer ODM services.

"I like that EMS providers are getting more into design engineering," says Theresa Metty, chief procurement officer for Motorola. "They are moving strongly into the ODM space without crossing the line of competing with us," she says. "That is compelling."

Shea, of Celestica, says OEMs want EMS companies to have ODM services because they want one-stop shopping. "Many of them have made it clear to us that they don't want to manage both EMS and ODM suppliers going forward," he says.

The trend toward ODM services obviously means EMS providers will have to hire more design engineers. "However, there is more to it than that," says Shea. "Another necessary ingredient is also having a relationship with some of the building block providers like an Intel or AMD or telecom chip provider and a relationship with standardization committees" to help influence technology development.

Turn the page

The trend toward ODM services marks the be-ginning of a new chapter in the EMS industry and may be key to the future success of the industry, according to Sachs.

He says in the early days of outsourcing OEMS would use EMS providers when OEMs needed extra capacity. Eventually OEMs began to trust EMS firms with more manufacturing and gradually electronics contract manufacturers became the primary manufacturers for many products.

"In the end what our customers do is design products and get them to customers," says Sachs. "The more you can help them achieve what they are trying to do in an efficient and cost effective way, the more they are going to value that. If you are just doing manufacturing, then you are not participating in enough of the supply chain to ensure the supply chain is functioning efficiently," he says.

While the movement to ODM services is a big trend, it is not the only one buyers involved in outsourcing decisions need to keep an eye on.

Buyers can also expect EMS manufacturing to shift to different geographies, and not just China. "A lot of companies are looking to expand their footprints in low-cost areas," says Miscoll. "Mexico has been ramping up over the last several months. They are climbing up the food chain."

A lot of high-volume, low-cost manufacturing moved from Mexico to China. "Mexico has accepted that a lot has gone away and they have shifted to more complex, low- to mid-volume, medium- to high-tech equipment manufacturing," says Miscoll. Such manufacturing includes automotive systems, industrial controls and aerospace equipment. However, there is also set-top box manufacturing in Mexico, which tends to be higher volume product. "Some companies that had moved manufacturing to China have moved back to Mexico. They have realized it is a good idea to keep these things closer to home," says Miscoll.

He says some subassembly work being done in China is being shipped to Mexico for final assembly and delivery to customers.

While a lot of commodity products are being made in China and other low-cost geographies, there are no hard and fast rules on which products should be manufactured where. Each has to be evaluated on a case by cases basis, says Sachs. However, there are some guidelines. "If the weight is high versus the value and volume, or if demand is extremely unpredictable and short delivery times are required, then there is a stronger case for manufacturing close to customers," says Sachs. If the product has a high value-to-weight ratio and demand is predictable, the product can be manufactured in a far-off geography, he says.

Sachs says total cost of ownership criteria should be used in determining where a product should be manufactured. Criteria should take into account unit manufacturing cost, quality, leadtimes, value and weight of the product, predictability of demand and inventory carrying costs among others.

Another key trend facing the EMS industry is the European ban of lead in electronics equipment, which goes into effect July 2006. The ban affects EMS providers the most because they are handling much of the manufacturing. They need to make sure they have lead-free parts and use lead-free manufacturing processes.

"We have invested time and energy looking at new processes, solder formulations, looking at the entire manufacturing side of this versus the product side, in an attempt to help our end customers," says Sachs.

EMS providers will also be on the front line in dealing with the part number issue for lead-free parts. Many suppliers want to use the same part numbers for lead-free parts as they did for the leaded parts while some OEMs and distributors are calling for new part numbers for no-lead parts. The issue is important because traceability is a key part of the ban on lead.

"Documenting traceability for parts is important. It's necessary to show that parts being used are compliant with the European initiative," says Miscoll. "There are questions about materials being substituted."

Another trend buyers should watch for is the effort of EMS providers to convince OEMs to entrust them with more strategic sourcing responsibility. EMS providers say that their buyers take a more comprehensive view of the supply chain, which can benefit the OEM customer. "In most cases we find when we are materials constrained for production needs from our customers, it is always due to the customer's specified supplier, not ours," says Sachs. "When we spec in suppliers we think about overall supply chain performance. We don't just think about cost. We think about leadtime and flexibility, etc."

He says OEM engineers designing product may not necessarily be thinking about total cost when they design and spec in suppliers. After a product is designed, "our ability to go back to a supplier and fix a situation is often limited," says Sachs. "Increasingly our customers are recognizing that and acknowledge that we can add some value. They are turning to us for a larger portions of their bills of materials."

Leaders in annual sales growth

SMTC has most revenue per employee

Top original design manufacturers

Top 50 Contract Manufacturers

Leaders in communications

Leaders in computers & peripherals

Leaders in consumer electronics

Leaders in industrial electronics

Leaders in medical electronics

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