According to various reports, many North America electronics manufacturing services (EMS) companies are losing share to their Asian counterparts. In many instances, Asian EMS firms are offering steep price discounts to win OEM customers, often at a loss to the EMS provider where, in his view, the trade-off is worth it if he can penetrate a market or hold onto / build market share.
In the hyper-competitive EMS industry, understanding OEM customer relationships and end-markets is critical for any EMS company wanting to retain or build business.
According to EMS sector analyst Jim Suva (Citi Bank), there are 4 major themes, or phases, in the EMS sector. We’re in the midst of this four-phase EMS industry cycle right now.
Phase 1 dealt with OEMs lowering orders / volume due to lower end-market demand.
Phase 2 (underway) is dealing with some OEMs in-sourcing (moving business away from EMS) to fill internal operations. Not all OEMs are equally capable and prepared to handle in-sourcing with some better equipped than others.
Both phases 1 and 2 can create negative EMS margin leverage making things a bit more difficult for the well-run EMS companies and outright horrible for EMS companies trying to survive this downturn.
Meanwhile, we’re also entering the folds of phase 3 which involves OEMs restructuring and either incrementally outsourcing programs or trying to sell unwanted assets to current or potential EMS partners.
Phases 3, 4 and beyond
Coinciding with the entry of Phase 3 in 2009, other industry landscape changes to evolve include:
- more asset and goodwill write downs
- increased liquidity and balance sheet strength
- changes in capacity utilization rates
- changes in OEM in-sourcing / outsourcing trends
- inventory rebates
- pressure on average selling prices (ASP)
- increased end-market demand and relative exposure
- more restructuring efforts
Phase 4 will emerge only as things have already begun to improve economically with a macro recovery and demand returning across end-markets.
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Undoubtedly, this will leave OEMs with not enough in-house capacity to meet customer demand — which will drive more outsourcing to EMS companies.
Essentially, a seismic shift is unfolding in the EMS industry. The competitive EMS landscape and margins have permanently changed. Such changes could be seen as welcomed news by many EMS providers because in time these changes could help drive margin expansion.
During phase 4, while economic recovery is truly underway, and OEMs are crunched for capacity due to shortages, OEMs will (routinely) also try to sell their assets to EMS companies.
Typically, these transactions have not worked out well for EMS companies when compared to a true outsourcing ‘win’ by the EMS provider because the latter situation offers more favorable terms to EMS companies. Additionally, OEM asset sales can often result in restructurings, labor union and government negotiations / re-negotiations, unanticipated challenges and costs, not to mention extending timelines for companies to reach economic profits or at least break-even.
With all of this unfolding in industry, EMS companies also need to be on the look-out for non-traditional ways of building sales.
EMS areas gaining focus with higher profits and growth (but, not enough to offset the competitive element of the EMS landscape) include end-markets such as medical electronics, automotive, aerospace and defense. Figure 1 shows key EMS focus segments with high growth against % TAM (total available market).
Fig. 1
EMS overcapacity
EMS providers such as Hon Hai (Foxconn International Holdings), Flextronics, Jabil Circuit, Benchmark Electronics and Plexus have each experienced significant capacity expansions over the past several years in places like China, India and Vietnam. This no doubt will place pressure on utilization rates (and margins) throughout 2009 as these companies, and others, also look to better understand their end-markets. (Figure 2)
Fig. 2
However, even as the majority of economic leading indicators (EMS industry-specific as well as regional and global economies) do eventually begin to show multiple signs of improvement and we truly are on our way to recovery, this still will not mean the EMS industry is out of the ditch.
There is too much capacity in EMS. Suva believes this excess will persist.
He even goes further to state contrary to expectations of many, “industry overcapacity will become even more pronounced.”
Suva estimates EMS industry capacity utilization ending 2005 was 62%, 68% in 2006, 70% in 2007, and was about 70% exiting 2008; far from optimal capacity utilization levels of 80% to 85%.
Meanwhile, the industry is seeing many EMS companies still in the midst of restructuring operations; taking charges with razor-thin profits and sometimes undercutting prices at unsustainable long-term levels in order to [try and] fill capacity.
EMS players are also still selling off and closing down plants. Those EMS plants being moth-balled are done so to take out immediate excess capacity with the idea the provider (hopes?) he will use it when things turn around.
For 2008, according to leading research firm IDC, the EMS sector’s Q3 was stronger than that same period for the ODM (original design manufacturing) sector. As the consumer sector collapsed, the EMS sector grew at 8% annually for both Q1 and Q2, then growth accelerated for Q3 to 9%, up a point from 2007, and then contracted by nearly 11% in Q4 2008.
As a result, IDC says the EMS sector’s revenues grew just 3% to $167 billion for 2008. The sector accounted for 58% of industry revenues, down from 61% of industry revenues in 2007.
Some industry estimates indicate EMS industry revenues could decline 15% to 25% in 2009 with capacity utilization exiting this year at possibly less than 70%, maybe even 65%, marking 2009 as the first year of utilization declines since 2000. (Figure 3, FIH is Foxconn International Holdings)
Fig. 3
What’s in it for OEMs?
Suva estimates it would take 2 years of 15% to 20% of annual EMS sector growth to get EMS industry utilization rates that eliminate overcapacity. Which, by the way, he claims is not even close to being realistic given his firm’s 5% annual growth rate estimate for electronics equipment plus a 1x to 2x EMS outsourcing multiple.
Suva also takes the position more consolidation among the large EMS companies, such as Flextronics’ acquisition of Solectron, is unlikely and vertical model subsidies are a reality of the future.
Simply put, despite 7 years of industry restructuring there is still excess capacity in the EMS industry and lower demand in 2009 could make conditions even more unfavorable across the industry.
All of this increased margin pressure across the EMS industry will spur increased competition among EMS providers with even more aggressive EMS services pricing and inventory terms which translate to giving OEMs more leverage.
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