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Electronics buyers need to be concerned about profitability of EMS providers. Increasingly, EMS providers are serving as the manufacturing arm's OEMs. If EMS providers can't turn a profit, buyers will have fewer manufacturing partners to choose.

While EMS margins are low, the industry is enjoying strong revenue growth. EMS revenue will grow from $109.5 billion in 2004 to $197.5 billion in 2009, says market researcher Technology Forecasters. At the same time, ODM revenue will grow 16% per year as sales rise from $69.5 billion to $148 billion in 2009.

Analysts say ODMs' growth rate is higher because many OEMs are looking for the design services that ODMs offer. An ODM designs the product, builds it, and ships it with the OEM customer's brand name on it. An EMS provider typically manufactures a product based on an OEM's design. However, ODMs will also offer just manufacturing services to an OEM customer and build a product based on the customer's design.

Because of the growth of ODMs, many major EMS providers are beefing up their design services. More are offering ODM-like services in an effort to improve margins. ODMs typically have margins of about 6% while EMS providers' margins are in the 2-3% range.

Improving margins is key to the long-term health of the EMS industry, says Eric Miscoll, chief operating officer for Technology Forecasters based in Alameda, Calif.

"We are at a very delicate time in the industry," he says. "The concern expressed is how will EMS providers achieve profitability again? These are for-profit enterprises. They need to generate profit, but profit levels just aren't there."

While profit margins are low and EMS providers will compete with ODMs for OEMs' outsourcing business, there appears to be plenty of business to go around.

The total available market (TAM) for electronics equipment in 2004 was about $1 trillion and the amount of business handled by both EMS and ODMs was about 19%. By 2009, electronics equipment TAM will increase to $1.8 trillion.

"When I look at that, it tells me there is more that can be outsourced," says Miscoll. "EMS in theory should be able to compete for that work. If we are at a penetration rate of under 20%, that tells me there is more opportunity."

There appears to be more opportunity across the board. EMS growth rates will be strong in all key customer segments.

EMS business from the medical industry will grow 18.8% annually through 2009. Automotive outsourcing will grow 16.7%; military aerospace, 13.2%; industrial, 15%; computers, 7%; consumer about 8%, and communications around 13.5%, according to Miscoll.

While there will be strong growth from medical equipment and automotive, more computer systems, consumer electronics equipment and cell-phone handsets will be handled by ODMs.

"Computers are going ODM," says Miscoll. "ODMs are the darlings of the computer industry. They grew out of the motherboard side of computer industry."

"ODMs lend themselves to commodity-type products. The majority of computer systems and peripherals are commodity products, as are handsets and consumer equipment. It's ODM business," says Miscoll.

But, with more OEMs outsourcing, EMS has the potential to boom if it can find a way to improve profit margins.

Miscoll says part of the EMS profitability problem stems from the "rock 'n roll era of the 1990s" when the EMS industry was booming. Many major EMS companies acquired the facilities of OEM customers and added a lot of capacity. They were optimistic that the electronics industry would continue to grow and OEMs would continue to outsource at a higher rate. OEMS did continue to increase outsourcing, but not at a high enough rate to boost EMS factory utilization rates, according to Miscoll.

Globalization also had a big impact on the EMS providers' overall business and profit margins. "Serving big multinational customers on a global basis has proven to be a very challenging endeavor," says Miscoll. He says the ODM model seems to work well in serving the large global OEMs.

"ODMs always had two sides of business and now they have three. They did traditional ODM and EMS work and now they are doing their own brand manufacturing (OBM)," says Miscoll. With own-brand manufacturing the ODM builds a product, puts its own name on it and sells it.

Some major EMS providers have seen the success of ODMs and have developed an ODM line of business. Flextronics, based in Singapore, is a good example. It has designed and built cell phones for OEMs.

Miscoll says over the next 10 years, EMS providers may have an OBM line of products as well. "Currently, they say they don't want to compete with customers, but at the end of the day you need to be profitable. If customers are squeezing the heck out of you constantly, you need to do something as a responsible business," he says. "Where are those higher margins? They are with own brand manufacturing."

EMS providers just don't have ODMs to worry about. They also face competition from indigenous Asian EMS companies.

"These companies are increasingly gaining ground and they are doing it with zero or even negative margins," says Miscoll. "How? The best answer that we are able to find is that there is some government support behind these companies."

Miscoll says many indigenous Chinese manufacturers are very competent. "There is a popular myth that Chinese can't do high-end manufacturing. I am hearing more from OEMs about how competent Chinese manufacturing is," he says.

He adds that Chinese manufacturers aren't just building low-value, high-volume products. "In some cases they do mid- to low-volume manufacturing that is more complex. They are getting better and are moving up the food chain and increasingly will be a power that will have to be contended with," says Miscoll.

He says to compete with emerging Chinese manufacturers and improve profitability, EMS providers with a global footprint need to improve factory utilization rates which are only in the 40-60% range.

"Those who have global footprints have too much capacity. They have to shut down plants or get more business," he says.

Miscoll says there are examples of companies that have strategies to compete and be more profitable. For instance, Flextronics has taken a multipronged effort to boost margins.

"They have sold off their noncore businesses," says Miscoll. Flextronics recently finalized a deal in which it sold off its semiconductor operation for $500 million.

"They are also pushing ODM platforms and at the same time approaching ODMs and saying 'partner with us.' Flextronics CEO Michael Marks went over to Taiwan and said to ODMs 'let us to do your manufacturing' because ODMs don't have a global footprint, yet their customers are global. It is a great opportunity and they [ODMs] don't have to do the capital investment in facilities," says Miscoll.

He says Flextronics is partnering with Asustek, an Asian ODM.

Jabil, based in St. Petersburg, Fla., is a profitable EMS provider that operates efficiently, says Miscoll. "Early on, Jabil didn't do acquisitions, but green fields," says Miscoll. In recent years Jabil acquired the facilities of Philips and acquired EMS provider Varian Electronics Manufacturing.

"Jabil is always focused, has very few customers and serves them well. Datacom is still as big a customer as it is a consumer. Jabil's top customers are Philips, Cisco, HP, Nokia, IBM, Marconi and Veleo," says Miscoll.

Jabil has lean manufacturing and other EMS companies are turning toward lean methodology to become more efficient manufacturers and hopefully become more profitable.

With lean, a manufacturer carefully reviews its processes and identifies areas of waste. Waste includes such things as overproduction, idle time, the unnecessary transport of materials and operations that add no value from a customer's perspective. Waste is eliminated and manufacturing procedures are simplified and speeded up.

With lean, overhead costs are often reduced, inventory levels are lower, quality is improved and manufacturing is more efficient.

The problem is few EMS providers have truly embraced lean. "EMS companies will tell you that they have it. Everyone has a good statement about it, but if you go to their factory and look for evidence of it, will it be there?" asks Miscoll. "One would wonder what the heck they have been doing. It is as if all of a sudden everyone has gotten religion. They are getting a lot of pressure from the OEMs for lean."

Miscoll says some companies like Celestica, based in Toronto, are further along with lean than others. In fact, Celestica began its lean manufacturing in 1999.

"The lean concept is nothing more than basically getting the waste out," says John Boucher, chief procurement officer for Celestica. "We have squeezed waste out of manufacturing and have done a good job of deploying lean across Celestica. Now we are moving it into areas beyond the manufacturing floor into the enterprise," he says.

Celestica is working closely with its suppliers to have a lean supply chain to support its lean manufacturing. "Lean forces us and our partners to see where the waste is."

He says a lot of waste is in the buyer-planner process.

"Fundamentally, the whole buyer-planner process is typically a materials resource planning (MRP), regenerative planning kind of concept. It is time-based planning," says Boucher. "With lean it is more of a kan-ban pull replenishment type of planning logic. Replenishment quantities are all tied to a kan-ban process vs. an enterprise resource planning, which is time-based," he says.

Boucher says lean means that companies can do more with less. "I have a buyer-planner, my customer has a buyer-planner and my supplier has a buyer-planner," he says. With lean methodology, there is only one buyer-planner.

"My ideal model is my supplier has a buyer-planner who sits in my operation, or more importantly operates off my MRP, which has demand pull logic from my customer," he says. I have eliminated two of three overhead resources and condensed the time from demand change to end supplier response. That's what we are doing."

He says the methodology can be applied to component engineering, product data management and product documentation centers.

Solectron, based in San Jose, Calif., is another major EMS provider that is moving toward the lean model. "We are 100% committed to deployment of lean and to the engagement of lean throughout the supply chain," says Perry Mulligan, chief procurement officer. "We believe it is fundamentally the way we provide a difference, a better solution to our customers."

Mulligan says Solectron has held about 80 "kaizen events" with suppliers. Kaizen events map out processes, identify areas of waste and areas where a process can be improved.

Mulligan says lean will have a big impact on purchasing at Solectron and on its supply base.

He says lean will result in considerable consolidation of Solectron's spend. "Not every supplier is going to have the same aptitude, willingness, and energy to invest in this, so we believe we will be doing more with less. We'll be doing more business with fewer suppliers as a result of lean," says Mulligan.

He says a company can't do lean programs with seven or eight suppliers of a particular part. "You typically find one or two suppliers with the best solution for that space and work diligently with them."

He adds that purchasing's role will also change. The "traditional procurement practices" are almost completely eliminated, says Mulligan. "In many companies purchasing is perceived as the organization that schedules materials into the facility through MRP output and the purchase order logic. What we are doing with the lean initiative is replacing that with a replenishment signal. The replenishment signal is a visible signal to the supply base and it becomes much easier for suppliers to see our true consumption pattern and they respond to that," he says.

Mulligan says in some cases buyer positions may be eliminated and in others, buyers will be redeployed in more strategic supplier management roles.

However, the purpose of lean is not to reduce the number of suppliers or buyers in an organization. "That is a byproduct," says Mulligan. He says the idea of lean is to offer the best solution to customers with regard to flexibility, responsiveness, quality, and cost. "Our lean initiative will give us the opportunity to implement a supply chain that achieves that goal."

More EMS providers will likely turn toward lean. If they can use lean techniques to cut overhead, reduce cost and improve efficiency as OEMS outsource more manufacturing, the EMS industry will boost margins and will thrive. If EMS providers cannot find ways to be profitable, consolidation in the industry is inevitable.