EMS Industry –
Restructuring in preparation for an end market rebound
Harish Aiyar, Ph.D., Research Associate

Although corporations have yet to see a broad uptick in top line growth, the cost-cutting initiatives many have undertaken are beginning to bear fruit and should accelerate earnings going forward. The electronics manufacturing services (EMS) industry is no exception.

EMS companies provide all facets of the manufacturing process — from design, assembly and testing to distribution and repair services — to original equipment manufacturers (OEMs). The industry has evolved over the past two decades from a “safety valve” for OEMs to an integral partner. Many OEMs use EMS companies to the extent that they never touch the end product. The global EMS market is estimated to be $100Bln (2003) and is expected to grow to $170Bln by 2006.

During the late 1990s, EMS companies added capacity (through acquisitions and organically) at a record pace, only to face a dramatic downturn in demand. That required these companies to shutter facilities and reduce their workforce. On average, EMS companies have laid off 25-35% of their total workforce and have removed nearly 25-35% of capacity. Despite these measures, capacity utilization remains low (50-60%) and industry restructuring activity continues.

Inventory turns, cash conversion cycle and debt-to-capital measures reveal how effective restructuring activities have been, and highlights the potential leverage in the model. On average, inventory turns for the EMS group declined from a peak of 9.6x in 1998 to 4x in mid-2001. Since then, the group has reduced inventories each quarter and turns have improved to greater than seven times. During this same time period, the cash conversion cycle for the group increased from 42 days to a peak of 73 days. Since then, the average cash cycle has returned to historic/pre-bubble levels. As a whole, balance sheets are strong, with long-term debt to total capital near 10-year lows at 20%.

However, organic top line growth remains anemic for the group. Many EMS companies have demonstrated top line growth in recent quarters, but this was primarily a result of mergers/acquisitions or OEM divestiture deals. Weak end-market demand, low capacity utilization as well as pricing pressure, have combined to compress margins. Average gross margins have declined from nearly 10% in March’99 to 6% in March’03. As utilization improves, margins should return to historic levels.

Major EMS companies include Flextronics, Celestica, Sanmina-SCI, Solectron, Jabil Circuit, Benchmark and Plexus. These companies differ in regard to scale, service offering, end market exposure, geographic presence, and customer diversity. Flextronics is the largest EMS company, rivaling many OEMs in annual revenue. The company has the largest footprint in low-cost regions, boasts some of the best operational metrics in the industry, and has a broad customer base. In 1Q03, its top 10 customers accounted for roughly 50% of revenue. Risks include its exposure to consumer spending and its printed circuit board fabrication business.

Jabil Circuit has been aggressive over the past year on the acquisition front (e.g. Philips and Valeo outsourcing deals), which has helped to diversify its end market exposure. As with Flextronics, a key risk is its growing consumer exposure.

The long-term outlook for this industry is positive. EMS growth opportunities are real, and will come from secular outsourcing trends, industry consolidation, OEMs consolidating vendor relationships, new markets and end market demand. Although pricing pressure will persist, EMS companies will benefit from increased switching costs for customers if they differentiate their offering with higher margin, value-added services. Those EMS companies with a diverse customer and manufacturing base, as well as strong operational metrics, will emerge as winners.

Executive Insights
Tom Smach, Senior Vice President of Finance
Flextronics, [NASDAQ: FLEX]

Q: How has the role of EMS companies like Flextronics changed over the past ten years?

A: A decade ago, original equipment manufacturers (OEM) primarily used electronic manufacturing services (EMS) companies to offload their peak manufacturing requirements and to balance internal capacity needs. Since then, OEM companies have significantly increased the outsourcing of their core activities, and look to EMS companies to provide fully integrated supply chain services.

Q: How large is the EMS market in which Flextronics operates, and what is your share?

A: The estimated current value of the EMS market is around $100 billion, which represents roughly one-eighth of the $800 billion worldwide electronics industry. Flextronics is by far the largest EMS provider in this a highly fragmented industry, and currently owns 14% of this market. Other tier-one EMS providers include Solectron Corp., Celestica, Sanmina-SCI, Jabil and Hon Hai.

Q: How does Flextronics’ vertical integration model differ from those of its competitors? Is this approach gaining acceptance among yourOEM customers?

A: Flextronics has been an industry pioneer in the move to full vertical integration. This has enabled us to provide customers with a suite of services that covers nearly the full spectrum of the supply chain. On the front end, we offer our customers full product design, component manufacturing for printed circuit boards, and design and manufacturing of plastic and metalenclosures. On the back end, we provide repair and warranty services, as well as logistics functions that help customers reduce redundancy throughout the supply chain. As outsourcing becomes increasingly popular among OEM companies, our vertical integration model continues to gain momentum.

Q: What are the advantages of Flextronics’ worldwide “industrial park” approach?

A: Flextronics has developed integrated industrial parks to maximize the advantagesof our global, large-scale, high volume capabilities, and to reduce production costs. These parks are strategically positioned in regions of the world where real estate prices, utilities and manufacturing costs are low, and often are located in low tax jurisdictions. The ability to manufacture and ship products directly from our parks significantly reduces overall freight costs. In addition, decreased shipping lag time provides our OEM customers with two key benefits: higher flexibility to respond more rapidly and effectively to consumer demands and decreasing time-to-market.

Q: Is price the main driver for an OEM when it is time to choose an EMS partner?

A: Pricing plays a relatively minor role in this decision process, as OEMs are able to obtain market pricing from virtually any supplier. In our business, relationships and capabilities are the main determinants. Flextronics’ value proposition is our ability to fully understand our customers’ needs, and to rapidly deliver integrated supply chain management solutions that significantly reduce costs and time-to-market.

Q: How would you describe your business development strategy?

A: In the electronics segment, acquiring new customers is not the primary focus of our sales and marketing efforts, as we currently have significant relationships with the majority of the key OEM players. We prefer to concentrate in further expanding our existing relationships and winning additional outsourcing contracts primarily from our established customer base.

Q: Are there any specific markets that Flextronics has not historically participated in, that you hope to penetrate in the future?

A: We believe that the electronics industry will continue to be, by far, the largest outsourcer. There are certain attractive segments in which we are actively trying to expand our presence, and these include semiconductor capital equipment, automotive, medical, and industrial.

Q: Has SARS impacted your business?

A: SARS has created some inconvenience as a consequence of our need to implement precautionary measures worldwide. From an operational perspective, however, it has not caused interruptions of our global operations or had an adverse economic impact.

Q: What do you perceive to be Flextronics’ largest opportunities, looking ahead?

A: Our biggest opportunities centersaround the continuing trend in outsourcing. Currently, the worldwide electronic market outsources only 14% of its manufacturing. However, reliable industry studies and customer surveys anticipate that during the next several years, outsourcing will grow to nearly 70%. The growth of this secular trend, combined with the ongoing expansion of our vertical integration model, will enable us to significantly increase our revenue stream from supply chain services.

Q: What area of the outsourcing market is growing the fastest?

A: Original design manufacturing (ODM) is growing at a faster pace than any other service. Flextronics is well positioned to take advantage of the significant potentials for revenue growth offered by this sector.

Q: Are acquisitions included in Flextronics’ growth plan?

A: Acquisitions aren’t slated to play a major role in Flextronics’ current strategic plans, although we are prepared to consider attractive opportunities. However, our major focus now is to continue to add capabilities and expand services, rather than to purchase market share.