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Is it Time to Change CM Business Models?
December 31, 1969 |Estimated reading time: 9 minutes
Rapid growth, mergers and margin shrinkage are just a few factors forcing change in the CM industry.
Mark Lyell
Do we need new contract manufacturing (CM) business models for the new millennium? Industry trends are forcing changes in CM operative paradigms because of an open-ended total available market (TAM), rapid growth, merger mania, supply-chain mutations, margin shrinkage and e-commerce ebullience.
Investors are bullish when it comes to the CM sector, pushing stock prices higher and higher, which seems unusual for a low-margin business. There are two key ingredients attracting the attention of savvy investors.
The first ingredient is actual and potential growth: The total available market for electronics outsourcing (estimated at $600 billion and growing) is under-penetrated. Revenues in 1998 for the CM industry were $60 billion, suggesting a market penetration of only 10 percent. CM industry growth worldwide historically has been 20 percent or greater per year. There is no clear end of this expansion in sight, which leads some analysts to call the industry "bulletproof." It is preferable to think of the industry as analogous to the Levi`s blue jeans market during the 1849 gold rush era - a great business while it lasts, but what do you do for an encore?
The second ingredient is return on assets (ROA). Although industry margins are low, CMs turn the cash over very quickly to create margin. Resources deployed generate profits in a much shorter length of time than in other electronics sectors and with much less risk.
This is a solid growth scenario for CM suppliers and for OEM customers that depend on their CM`s ability to adapt to an ever-changing market by always finding new value to add. However, recent and future developments in the industry may change this relationship entirely.
Margin Disparity
OEMs are now dictating margins to CMs, and margins are going down. This may make OEM shareholders happy, but in time, this trend could significantly weaken their own supply chain. What prominent industry analysts refer to as the "hollowing-out" of the OEM is their increasing urge to outsource everything to focus on their core competencies.
This trend is expected to result in OEM dependence on their suppliers. The disparity in perceived value for the design and marketing functions (OEM) vs. the manufacturing and logistics functions (CM) creates potential conflict between the two.
This is because the margin equation is weighted heavily in the OEM`s favor, because of both inherently high margins (55 to 65 percent) dictated by their business models, and because they control their suppliers` margins (in the 4 to 7 percent range for the typical CM focused on PCB assembly).
The only force that offsets a potential collision between OEMs and CMs is industry growth. And the single greatest source of CM growth is OEM divestitures. As reported by Technology Forecasters, 65 percent of all CM growth is through the acquisition of OEM facilities. As long as this growth-by-acquisition trend continues, the two independent industries will continue to prosper, albeit in delicate balance.
The current rate of growth will eventually lead to a saturation of the total available market. There are many debates regarding the amount of time this process will take. However, if the trend stays constant, major penetration will be noticed in five years and completed in less than ten (Figure 1).
Should this happen, it could have a profound impact on the delicate balance between OEM and CM. Using the analogy of Levi`s blue jeans will help to understand the changes that may occur in the CM industry.
Blue jeans were specifically designed for the rigors of mining and other rugged outdoor activities and sold incredibly well during the gold rush period. Other purveyors of goods also benefited from the gold rush phenomenon, yet are no longer household names. After the gold rush was over, Levi Strauss became a household name by finding markets for blue jeans other than miners or laborers.
Many experts predict that the first decade of the new millenium will be called the "gold rush in outsourced electronics manufacturing." Who in the CM industry will find new markets and perhaps become a household name? And how will this occur? How will the CM industry maintain shareholder expectations in a market whose margins are declining, and moreover, where growth is expected to saturate the industry?
These and other questions naturally come to mind when considering a scenario of change and possible paradigm shift.
Consolidation
Must the CM industry go through massive consolidation similar to what is currently happening in the electronics distribution sector to gratify or maintain shareholder expectations?
Consolidation has been an effective way to keep the shareholders of the declining margin electronics distribution business happy. (Declining margins are due primarily to the CM sector becoming distribution`s fastest growing customer base.) Yet consolidation in distribution is a mixed bag for mid-tier OEM/CM customers. Procurement of many component lines from a single supplier helps to lower material logistics costs, but service is much worse than from smaller suppliers competing for the business. A significant part of distributor consolidation success is because of a business model that allows the convergence of customer bases and the ability to support thousands of purchasers.
Consolidation presents problems for the CM sector and its customers in particular.
Mass consolidation is against the fundamental objective of the CM paradigm, which is a limited customer set with a focused profile, whereas the acquisition of companies means an unwieldy, over-large customer base. Historically, CM acquirers cherry-pick the customer base of its acquisition, which leaves many orphans in its wake. Consolidation can only be effective when tier-one CMs devise a strategy to service mid-tier OEMs. This is meaningful precisely because these OEMs represent the largest revenue opportunity in the TAM. The unanswered question is, how do top-tier CMs support mid-tier OEMs?
The key to managing a successful CM is to make sure your customer base fits your most stringent profile, and have the fewest customers possible.
Acquisition
Recent moves by semiconductor manufacturers indicate that they will not participate in the eroding margin game. They expect to avoid a collision with customers by separating commodity business from value-added business. In time, this will mean that both OEM and CM suppliers will be told where to buy and at what price. This could have a significant impact on component procurement and margin structure.
What was once two separate supply chains (CM/electronic distribution) with margins for both has collapsed into one. CM suppliers currently have an upper hand because of lower transaction costs and higher return on assets, but this advantage could change with the commitment to a demand creation model by the component manufacturers.
One can only speculate about acquisition motives, yet there are several reasons a CM might think of acquiring a distributor. Distributors understand material logistics far better than a CM; they are farther in the e-commerce implementation cycle and they under- stand how to support a larger number of customers without being a competitor to their CM customer base. Owning a distributor and eliminating double markup could increase CM margins. The problem is that there are very few worthwhile distribution acquisitions left and a lot of competition for them.
Buy Back
Will CMs buy back facilities that are far more efficient than those sold, and at a discount?
The selling of manufacturing facilities has been a lucrative proposition for all parties, although in reality it greatly favors the OEM. General Electric`s Jack Welch`s "lean and mean" philosophy counteracted a complacency in America`s business practices and catapulted the company to the most valued company in the world, an example which received the attention of the world`s economic community.
Over the last 15 years the CM industry emerged, built on the practice of OEMs emulating "lean and mean" practices by outsourcing. The CM industry has picked up the practice, which continues to be a key ingredient in its recipe for success.
Another way for OEMs to become "lean and mean" is by divesting to those CM firms that know the formula. So if the market becomes saturated and the growth less than experienced in previous years by CM shareholders, will the stock significantly deflate in value? If this happens, one can speculate that OEMs may acquire efficiently run CM facilities. It is unlikely that an OEM would compete with its own supplier, but specific properties could benefit operations.
OEM/CM Balance
Does e-commerce create enough cost savings to keep the delicate OEM/CM balance intact? Who will drive and deploy it, the OEM or CM?
One way to counteract eroding margins is to eliminate cost. E-commerce could play a significant role in this process. Material logistics have always been a difficult and costly part of the CM business. There is no easy way to deal with the multiple part numbering systems of the customer`s controlled documentation, and ERP systems addressing this complexity are expensive to buy and even more expensive to maintain. The new XTML e-commerce language promises to become a generic system transaction with more data and flexibility than EDI. Its deployment will allow the planning systems of the CM and its suppliers to merge. Today each link in the supply chain has its own planning system. As these systems merge through common transactions, it will shorten the supply chain and reduce redundant activities, enabling CMs to move toward a true demand flow manufacturing model.
The questions then are who will drive such adoptions and who will pay for them? OEMs say that they need to be the drivers of real progress with their CM providers, a situation not likely to change. With margins being forced down by OEMs, investment in technology for all but a very few CM providers centers on manufacturing. The CM will make sure that whatever advanced packaging technology emerges or whatever expanded manufacturing service its customers requires is available. Because OEMs have historically driven business practices, e-commerce implementation should be considered one of these practices. This is not wasted effort on their part. The OEM can use these tools to reduce their internal costs and those of their suppliers.
Adding Margin
Should multi-billion dollar CMs add margin by designing, manufacturing and distributing their own products?
The CM supplier has some advantages. They have been peering into their customers` business for years and have become experts in several industry segments. It is not an unreasonable thought that a CM could borrow the best practices from their customer base and acquire technology through a licensing agreement with their own customer (or better yet, from a competitor`s customer) to add margin. Although there will probably not be an outright move for a CM to compete with its customers, it does make sense to acquire specific technology and add more components to an assembly. There are many unused patents that could be licensed. The CM could become an OEM for specific technology. This could allow OEMs further outsourcing opportunities and give the CM a much higher margin for its own technology.
Conclusion
The electronics OEM industry, in pricing and distribution turmoil - from semiconductors to the consumer (and don`t forget the Internet) - must find new models for doing business. For the past dozen years, it has coped admirably through outsourcing. However, the outsourced CM tail, in some respects, now wags the OEM dog.
The solid growth scenario predicted for CM suppliers, and for their OEM customers, depends on the CM industry`s ability to adapt by always finding new value to add to its services. With numerous opportunities and potential for conflict between OEMs and CMs, the future individual impact of the above questions cannot yet be discerned. If some of these issues arise, it may mean finding a new paradigm for success.
MARK LYELL may be contacted at ACT Manufacturing Inc., 4950 Patrick Henry Drive, Santa Clara, CA 95054; (408) 982-9999; Fax: (408) 982-9922; E-mail: mlyell@actmfg.com.
Figure 1. CM growth threatens to saturate manufacturing activity.