NEW YORK-With NEC Corp. and Sony Corp. serving as “trend setters” among their in-country peers, Japanese electronics equipment companies are poised to follow the lead of their American and European competitors toward contract manufacturing, said Peter McGowan, managing director of the Lehman Brothers Inc. technology investment banking group.
“The Japanese kiritsu model, the envy of the 1980s, has given way to envy of the U.S. outsourced manufacturing model,” he said at a recent media briefing about the electronics manufacturing services (EMS) sector.
“Japan is a huge opportunity because it will have to disassemble its vertically integrated companies.”
Citing client confidentiality and competitive advantage, McGowan declined requests to identify other Japanese electronics manufacturers actively considering the move to outsourced production.
“The Nortels, Lucents and Ericssons of the world joined the bandwagon after seeing IBM perfect that model,” he said.
“Cisco (Systems) and others decided to focus on their core competencies and perfect the idea of the virtual company. It is unlikely they will go back.”
In tandem with the growth of their potential corporate customer base, contract manufacturers also have expanded their expertise and offerings.
“They have gone from manufacturing circuit boards only to manufacturing whole devices to full system assembly, or full box and build, which includes packaging and shipping,” McGowan said.
“OEMs (original equipment manufacturers) now are asking their help in designing products. They have also gone from contract manufacturing, in which the OEM owns the products, to relationships in which the EMS owns the inventory, taking it off the OEM’s balance sheet.”
Last year, Lehman estimates that Wall Street investment banks collectively earned about $500 million in underwriting and other transaction-related fees for EMS companies, McGowan said. The largest of the players in this sector include Solectron Corp., Flextronics International, Celestica Inc., SCI Systems Inc., Sanmina Corp. and Jabil Circuit Inc. Mid-tier players in this group include ACT Manufacturing Inc., Plexus Corp., SMTC Corp., Pemstar Inc. and Ddi Corp.
In an industry sector that is only about five years old, it is noteworthy that Solectron, SCI and Jabil Circuit already are investment-grade companies. Other top-tier EMS companies are “poised to be investment-grade,” said Louis Miscioscia, senior electronics manufacturing services analyst for Lehman.
However, Solectron has not escaped the duress imposed by the current economic environment, despite its ranking as EMS industry leader with worldwide sales of $20 billion for the 12-month period that ended in March. Moody’s Investors Service Inc. recently revised its outlook for the bellwether company to “stable from positive,” and Standard & Poor’s Corp. to “negative from stable.”
“They (EMS companies) have a good deal of liquidity because they did a lot of capital-raising last year. Growth is a two-edged sword, though. It looks great on the top line, but you have to make a lot of bets on the future,” McGowan said.
“Margins are very low in this business. It’s a very tough industry.”
Contract electronics manufacturers must work down an inventory backlog. In a broader sense not specific to this sector, the backlog is a key contributor to the current economic slowdown.
“It is not only an inventory correction (for EMS companies), but demand is also weak. … Everyone wanted to be in the telecom area last year, but it’s not so hot today,” Miscioscia said.
“Today we’re at a crossroads. Asia tanks, Europe tanks, and there is a downward trend in the United States. The more optimistic view is that a tremendous amount of the bad news already is out. EMS could emerge as one of the few tech areas to see actual growth by year-end.”
During the past several years, outsourced electronics manufacturers have bulked up through acquisitions to gain flexibility and economies of scale. That trend raises the question of whether the outcome could be a paucity of EMS players that might become problematic for their OEM customers.
“Most of the tier-one companies are pretty much filled out geographically. Going forward, there may be more strategic deals driven by customer needs or by gaining a new capability, like optical components manufacture, which is not automated yet,” McGowan said.
Despite consolidation, the EMS sector remains highly fragmented, with hundreds of players, Miscioscia said. “At last in 2000, the mid-tier group came into its own. OEMs, concerned about giving so much business to the big EMS players, realized it is better to give some of their business to the mid-tier,” he said.
“A prolonged slowdown could propel mergers by the mid-tiers, but that might be problematic because share prices are so low.”
Although an exception, there also have been cases in which an OEM has hedged its bets by taking an equity stake in an EMS company or buying it outright, McGowan said. In early 2000, Motorola Inc. purchased a minority ownership share in Flextronics, which also provides it with outsourced manufacturing. In January, Kyocera Wireless Corp. purchased Tycom, an EMS company.
Within five years, McGowan also expects that the industrial landscape of electronics manufacturing will undergo dramatic changes as different kinds of well-financed companies get into this business.
