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Vertical Integration: A Growing Trend for EMS Companies?

As a general rule, Wall Street and electronics industry analysts love a consistent business model because consistency begets predictability and predictability begets dependable returns. Regarding the vertical integration of product services, electronics manufacturing services (EMS) companies have been very consistent and predictable.

Several EMS companies have changed their traditional business models by vertically integrating their services and themselves.

For nearly two decades, EMS companies have been vertically integrating their product services, from parts consignment to turnkey services to design for manufacturability to product design and system build.

As an example of this trend, a new IPC study reports that 84 percent of all EMS companies surveyed were participating in system build programs for their customers. [1] These companies represent about 41 percent of the total market.

Conventional wisdom might dictate that system build services would be the purview of only the large, top tier EMS companies. However, according to the study results, EMS companies with revenues of from $50 to $100 million grew their system build as percent of revenue from 19 percent in 1998 to 42 percent in 2000. In addition, for companies with revenues between $10 and $50 million, system build accounted for 32 percent of their revenue. EMS company revenue sources include sales of PWBs and components, assembly services, test, engineering and design services, product design, prototyping and repair and rework.

To further bolster the idea of vertical integration of services, the front end of the product, including engineering and design services and product design, accounted for nearly 5 percent of the source of EMS company revenue. This 5 percent equates to over $600 million in EMS company revenue for the IPC study participants. If projected over the entire EMS industry, the 5 percent in engineering, design and product design services by EMS companies would exceed $2 billion.

EMS companies will continue to offer more services for the product from the original equipment manufacturers (OEMs). Why? Historically, EMS companies offered to buy the components and the PWBs for their customers. Certainly, a revenue source from mark-ups existed if the EMS company purchased the materials. However, EMS companies did not want to assume the added responsibility of materials management and all the problems of purchasing and materials resource planning (MRP) and enterprise resource planning (ERP) systems that went along with this service.

What they did want was to become even more valuable to their customers. They also wanted to control their own destiny. Under consignment, can you imagine the EMS company president telling the customer they are a bad supplier because the parts the customer provided were not solderable? Arguing with a customer is bad business; providing additional services is great business and a sure way to grow.

And the EMS companies have grown. The EMS industry increased by an estimated 25 percent from 1999 to 2000. [1] This growth continues to be fueled by the OEMs' drive to continue outsourcing not only their electronics assembly but virtually every phase of their product.

This outsourcing stretches throughout the major markets with, not surprisingly, telecommunications seeing the largest growth. [1] The computer industry, at 40.7 percent, is the largest market served by EMS companies, followed closely by a 36.1 percent share for the communications industry. Rounding out the markets are:

* industrial--8.5 percent

* instrumentation--6 percent

* consumer electronics--3.6 percent

* government--2.3 percent

* automotive--1.9 percent

* business/retail--0.9 percent.

A Different Vertical Integration Model

Picture a wheel with spokes radiating out from the center. This diagram was the business model for the EMS industry for the last 20 years. The center of the wheel was the EMS company, and the spokes linked the EMS company to its suppliers: the PWB manufacturer, component manufacturer or distributor, and the plastic or metal enclosure fabricator.

The relationships between the EMS company, its suppliers and its OEM customers were excellent and the embodiment of the virtual corporation. This nimble, efficient business model, where each member of the supply web concentrated on its own core competencies, eschewed the large vertically integrated corporation.

This business worked for OEMs because it allowed the OEMs to:

* outsource their excess capacity

* introduce surface-mount technology without investing in capital equipment

* introduce new or existing products without investing in new facilities

* achieve faster times to market

* access global manufacturing

* achieve high quality and supply chain efficiencies.

Over the last several years, the EMS business model has become less predictable. Several EMS companies are now offering vertically integrated services and vertically integrating themselves. Specifically, they are purchasing companies within the supply chain.

For example, in 1996, Sanmina Corporation, once strictly a PWB manufacturer, purchased the assets of Comptronix Corporation, an EMS company based in Alabama. In late 1998, Sanmina purchased Altron Corporation, both an EMS provider and PWB manufacturer. Finally, early last year, Sanmina Corporation purchased Hadco Corporation, one of the world's largest PWB manufacturers.

This "self-integration" by the EMS industry is not limited to PWB manufacturers. Last year, Flextronics International formed a business enclosure unit that combined the recent acquisitions of Chatham Technologies and Lightning Metal Specialties with Palo Alto Products, which produces high-volume, midrange enclosures. Needham & Company estimated that sales for this unit should equal $1 billion in fiscal 2001 and as much as $1.5 billion in fiscal 2002.

In November, SCI Systems Inc. of Huntsville, AL, announced an agreement to acquire CMS Hartzell Inc., of Lexington, KY. CMS Hartzell is an electronics enclosure manufacturer with significant engineering capability and manufacturing expertise in sheet metal fabrication, plastic molding and die casting.

SCI Systems Inc. and Flextronics International are part of a growing list of EMS companies that have enclosure capabilities, including Viasystems Inc., Sanmina Corporation, C-MAC Industries Inc. and Kent Electronics. Enclosures are big business. IPC estimates that the North American enclosure market may have reached as high as $10 billion in 2000.

Regarding e-business, Solectron Corporation, SCI Systems Inc. and other original equipment manufacturers (OEMs) including Agilent Technologies, Canon, Compaq and Samsung are funding Converge, Inc. Converge is an online distribution channel that will allow users to buy, sell, auction and exchange information.

Why would EMS companies, so successful in the past in creating a new strategic outsourcing model, purchase their suppliers and, as a result, mimic the OEM structure they fought so hard to replace? First, they would be able to offer a wider range of services that might not always be available to them. They would also have more control of the supply chain. They could also lower costs and better control quality. Finally, they would be able to expand and contract service offerings.

Pure-Play EMS

Fearing, perhaps, they will take on the overhead burdens of the OEMs, other EMS industry leaders are confident in the "traditional" EMS strategic alliance supply chain formula. For example, Tim Main, president and CEO of Jabil Circuit Inc., said in November 2000 that Jabil's plans did not call for any PWB manufacturing acquisitions. In pointing out supply chain challenges, he said that Jabil is "getting comfortable with suppliers that are proactive and forceful; bring value-add from their expertise; are large scale, profitable enterprises and can be trusted."

Many EMS companies believe that managing a PWB manufacturer or enclosure company might not be their core compentency. Managing a PWB manufacturing company introduces many new issues ranging from environmental regulations to processing challenges.

Conclusion

Which approach is right? The companies that are internally integrating or those companies that are sticking to the traditional EMS model? Unfortunately for Wall Street, both business models have their strengths and weaknesses. The EMS industry will not and probably should not adopt the "one-size fits all" framework. The customers will make that decision, and, right now, they are apparently choosing both.

Reference

(1.) IPC. (2000). 2000 Market for EMS/Contract assembly companies. IPC, Association Connecting Electronics Industries.

Anthony Hilvers is vice president of industry programs at IPC, Association Connecting Electronics Industries, Northbrook, IL;
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Author:Hilvers, Anthony
Publication:Circuits Assembly
Geographic Code:1USA
Date:Mar 1, 2001
Words:1309
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