AUDIO – EMS emerging markets and worldwide industry trends with New Venture Research

Zetter: Hello, I'm Mark Zetter with Venture Outsource. We're talking with Randall Sherman, president and founder with New Venture Research. Before we begin our conversation, if someone in our audience has suggestions for future conversation topics, or feels there is a particular person they think would be well suited for an upcoming conversation, email us your comments or suggestions at insight[at]ventureoutsource[dot]com. Let's get started. Randall, you’ve followed the electronics industry for more than 20 years. Part of the knowledge you have required over the years is rooted in the semiconductor and EMS markets. In fact, listeners should know we've known each other for a good part of those years. Your firm provides tech industry research and analysis on emerging markets, plus you also publish various reports, annually. One [report] in particular is the ‘Worldwide Electronics Manufacturing Services Market’, which deals with EMS and outsourcing. Listeners can learn more about other reports, analysis and your services on your site, newventurresearch.com. We’ll also display your site in the transcripts for this discussion when we later publish them on our site, ventureoutsource.com. Of particular interest for this discussion, as I mentioned, is the EMS market. Randall, what are your thoughts on some EMS markets continuing to develop in areas such as Thailand, Vietnam, and India? Sherman: Well, the EMS market has an amazing vitality to it. It’s continued to grow beyond all expectation, and actually, to our delight, has met many of the forecasts that we, at the time we made, just seemed impossible. So, when I started looking at this market it was about $20 billion in size, and today it is almost $300 billion in size. It continues to grow, and occasionally we see a little downturn. But, with regard to your question about emerging markets like Vietnam and Thailand, it has been around for quite some time, but India is certainly emerging…it’s indicative of the trend that we've always seen in this industry, which is to seek out low cost markets and in many cases, such as China and India, to develop a domestic market. So, a lot of these manufacturers are really building products that’ll be sold into those local markets. It seems like, today, Vietnam might be one of the lowest cost regions in the world, and it is really just a matter of standard of living and wage rates and the economics of that region. I think we're just going to continue to see low cost economies bubble up here and, either EMS companies are going to use them for export, such as Thailand does, or they are going to use them for both export and selling to the local population. In spite of all of the tendency for people to believe the brakes are going to hit one of these days, there just hasn’t been any sign of that.     Zetter: With regards to Vietnam, a greater percentage of their energy [resource] for the country, is coal which is dirty and doesn't have the efficiencies and the advantages of hydroelectric [power]. Obviously, the high tech sector is energy intensive. Do you see Vietnam's infrastructure being an issue? And, regarding India… I know they have stumbled with their [Indian] EMS initiatives and haven't had nearly the success that their software initiatives have had. Do you see those two nations overcoming some of these challenges based on these issues? Sherman: Well, you have hit on the key critical point here. Can the infrastructure of the companies support the company's manufacturing needs, which include power and communication and roads, and so forth. China was particularly aggressive with that. Now, they’re a coal-based economy, but they invested a lot into infrastructure, and that really drove the growth of the industry for the last decade or so. India, I think has many more challenges in that regard. Although there is infrastructure there, it is not particularly reliable. You get little islands of reliability, but I think Vietnam has certainly got those challenges. The evidence is that a lot of these EMS suppliers want to go there. I forget the last count we had of how many large company facilities there are, but there are at least a half a dozen, and it has just proved to be a very cost-effective alternative. Zetter: What about Thailand? Given the floods that have taken place and the disruptions we've all seen of the various supply chains / channels impacting many plans EMS companies have and, actually, the plans OEMs have? Sherman: It certainly begs the question of diversity, the need for second source suppliers, and spreading your bets across a number of different regions. Although, they should have expected that. They certainly weren’t prepared for the amount of flooding that took place, and it really put them back.  

"...when it comes to the final assembly and functional test and things like this, the OEM’s the one with the liability there."

- Randall Sherman

  A number of the companies that are based there, almost heavily in Thailand, were just put back on their heels for a good six months. Beyonics and Fabrinet, and others, who just completely changed their bottom line just this last year from being positive to being negative. When you become dependent on a particular location or operation, as many of these suppliers do, I think that speaks to another point. When you’ve got someone like Apple so heavily invested in Foxconn, you sort of have to wonder, are they putting all their eggs in one basket, and what could happen with that basket? Zetter: Taking a look at the non-traditional EMS markets, they’ve typically provided some of the best margins for EMS providers serving these markets – medical electronics, industrial, and so on… what are two barriers to entry you often see preventing many EMS providers that are interested in entering these markets from doing so? Sherman: Well, there’s certainly a skill set involved in all those – aerospace, defense, medical, industrial, and there are certain certifications, for example, that need to be acquired and developed to support those industries. In essence, the EMS supplier almost has to become a kind of ODM. I don’t know if the audience is familiar with the ODM, but ODM is essentially an OEM manufacturer that does contract manufacturing as well, as a sort of a sideline. A lot of the Asian suppliers like Acer and others were doing this - building their own branded products. There is a kind of ODM in these sectors. In the medical sector, for example, there’s a whole skill set there you have to learn, or acquire. And, the same is true with defense - it’s got its own language. It’s got its own names and its own requirements and mil specs, and so forth.   See, also: Top 10 EMS / ODM by ranking   It is true, as you point out, they tend to be the most profitable with sectors. In fact, it tends to be sometimes the only profitable sectors, but given the nature of the products, which are typically low-volume and high-mix and high-complexity, it does not leverage the top tier’s capabilities in the same way that a mid-tier or a lower third- or fourth-tier supplier would have who could be a lot more flexible, a lot more responsive.   It can bring in the engineering capabilities, vertical engineering capabilities that are needed, and as such, they’re not highly penetrated, I have to say, because to be perfectly honest, many of the products are simply not outsourceable. They’re either too complex or too low in volume and there’s no leverage, and it just doesn’t make economic sense to outsource, or partner, with a subcontractor. Zetter: I know a lot of the EMS providers serving these non-traditional markets, they also have to – you mentioned mil spec, these certifications, and different ISOs, and the repeatability for whether a medical product is a class one, two, or three for recall and pinpointing in the supply chain should issues come up in the field… Do you think this ability to manage their supply chains and the detail required for recalling products, and for really pushing back on their suppliers, do you think that’s preventing some EMS providers from being successful and serving some of the more demanding EMS markets like industrial and medical and automotive that have these high rates of quality that are required, because lives are risk. Sherman: To answer carefully I would say no. There are going to be limits that these companies, OEM companies, will engage the contract manufacturer. They will certainly have them manufacture the printed circuit board. But when it comes to the final assembly and functional test and things like this, the OEM’s the one with the liability there. They’re not just going to wholesale outsource the assembly unless it’s certain simple products like home thermometer or something like that, or more commodity types of things. But what we’re mainly talking about are complex systems – medical x-ray and MRI systems and… Although they [OEM] will engage with partners and they will require them to have certifications and accountability, there is a natural line that is drawn in these relationships that it just doesn’t – and very rarely have I seen many EMS companies engage to the full extent. They’re capable of it, but unless there’s enough volume there, many of the OEM companies just don’t see the value. Zetter: What trends do you see currently taking shape in the EMS industry worldwide? Sherman: Well, it continues to grow and expand. I think that’s the rising tide of the electronics industry and the continued innovation. It’s gone from a point where they were simple subcontractors, and the OEM was able to pound them down and get them to the lowest possible cost, to being the true manufacturers of skill. And many of these OEM companies… I mean, not the old-line ones, but telecom companies… For example; mobile phones, and wireless LANs, and pagers, and all that sort of stuff…have no skill left at all. Have no manufacturing capability at all. They’re entirely dependent on their partners. That’s been an interesting trend. And, one other that started to develop, which I thought was particularly innovative, is that the EMS companies are going further up the supply chain line. In other words, they’re starting to get engaged on the component level. A good example of this is LED lighting, which is essentially a semiconductor technology. But there are a lot of mechanical, such that, there is the glass, there’s the encapsulation, there’s the housing, heat sinks and things like that. A lot of the OEMs, for example, like Phillips, who would naturally be in the lighting business don’t want to touch that. They don’t want to do anything with it. So, EMS companies like Jabil and some of the others, even Flextronics, are positioning themselves to be able to manufacture things on a component level and provide the solar photovoltaic market…is another one where they’re, actually, not just making the solar panels but they’re getting into making the cells themselves. And this is a new break. This is quite a step, and requires a huge investment, and it remains to be seen whether or not it’s really going to pay off or, is a good move. Because, after all, if the OEM doesn’t make the components what do they make? They’re not just a marketing company like Apple or Cisco. So, in other words, [EMS providers] are gobbling up more of the supply chain as they go and, in fact, it’s almost the only direction they can go.  

"Foxconn is amazingly profitable but not in its EMS operations."

- Randall Sherman

  Although I don’t think we’ve hit the roof, so to speak, of the total available market - I think there’s a lot of total available market left – but, whether or not that is subcontracted to a partner, or not, remains to be seen. Zetter: Total available market for the EMS providers to take in, you’re saying. Sherman: That’s right. The total available market is quite large. It’s over one trillion dollars right now, just in costs of goods sold. Zetter: I’ve seen estimates from $1.3 trillion to as much as $2 trillion, I think by IPC. Sherman: It depends on what you’re counting. In our case, we’re counting the COGS, or cost of goods sold. Other people might be looking at in-product value. Zetter: There is talk… I know the Bureau of Labor Statistics – I think it was the BLS – they’re looking at including the design component, as well. The labor and money invested in product design as being included, and the GDP [of contributing nations worldwide] which impacts the value of the technology supply chain, worldwide. Regarding the forecast for 2012, one research firm forecasted 2012 total EMS market revenues to be nearly flat. You indicate, in your forecast, 2012 to have a compound annual growth rate of seven percent. What is your reasoning behind this? Sherman: Well, it seems to be just the overall momentum of this amazingly robust market. Now, we have seen definite weakening in the second half, and we put that number out. We’re fairly confident that, after coming off such a strong year, that that would be a fairly modest growth rate. So, with a little bit of the downturn we’ve seen, we’ve looked at the numbers of a lot of major suppliers and it has been a rough second half for them. So, it may not come out quite that high, but I’ve always continued to be surprised at just how robust this [EMS] market is. The curious thing about our business is that when you’re right on a forecast, it’s like nobody remembers. But if you’re wrong, no one seems to care. It’s part of the beauty… We get to pontificate on things and, hopefully, not take any punishment for it. Zetter: You mentioned Foxconn earlier. What are your thoughts on western OEMs, outsourcing their electronics manufacturing to China? What changes, if any, do you see occurring at Foxconn (which, by the way, is China’s largest private employer), given the pay increases for workers? Do you feel Foxconn could lose market share as labor becomes a larger component of its business practices with its OEM customers? Sherman: Well, as the fortunes of Apple go, so go the fortunes of Foxconn. That company [Foxconn] has amazing growth but it’s ridden on the coattails of Apple. There seems to be some evidence, at least we have it, that Apple is considering other suppliers. Second sources, and third sources. I’m not sure just how far along those are, but Foxconn has ridden an amazing wave of growth here, and it really is going be the indicator here - handle or the brake – its really going to be according to Apple’s fortunes. Yes. That will trickle through as they [Foxconn] increase the wage rates, and that will add to costs. Foxconn is amazingly profitable but not in its EMS operations. It’s amazingly profitable through its component divisions, and that’s where it’s really making money. You can’t really take much more out of the margins that Foxconn has in its assembly operations. When China gets a sneeze we get the cold, I guess they say. But, Foxconn is a bit of an exception. It tends to be a very brutal environment for workers and manufacturing, and I think Apple’s been somewhat negligent in turning a blind eye to a lot of [Foxconn’s] labor practices and so forth. We’ve all heard about the recent spate of suicides, which was awful. But when you look at some of the pressures, and the work tasks that are put upon these people, you wonder why they’re – well you don’t wonder why there’s not more. You never want more, but it becomes – you can start to see the rationale behind it all. I think Foxconn - with the commodity products it makes - the natural place to go is China because of the supply chain, because of the wage rate. There are cheaper places, but then you’ve got to mirror image, or copy, those operations in those regions, such as Vietnam, and I think some of that’s going to happen, particularly as Apple diversifies. I think a few other people are feeling nervous, too, who have all their eggs in the Foxconn basket. As they should. Zetter: Looking into your crystal ball, where do you see the EMS industry evolving over the next few years? Sherman: Well, we don’t see any signs of growth abating at all. It certainly is going to continue to grow. Both the computer and communications sectors tend to be the dominant sectors. Probably two-thirds of all assembly revenues come out of those. But, the businesses that make money, that are the most profitable, tend to be in those less commodity sectors. Of course, they’re not as large. I think we just see continued good growth. Some supplier consolidation, for sure, and some [EMS providers] continue to exceed where others fail. We’re still optimistic. I’ll put it that way. Zetter: Do you see any acquisitions among the tier-1 EMS providers? Sherman: Yeah, that would’ve happened a lot more quickly if these companies hadn’t been burdened with so much debt that they’re basically not worth anything. In other words, they may have a little cash but their debt exceeds all their cash, by far. So yeah, in some cases it’s just like, shoot ‘em and put them out of their misery or just let them die a slow death. But yeah there will be consolidation. I’m sure of it. Zetter: Again, we’re talking with Randall Sherman, president and founder with New Venture Research. Randall, thank you. Sherman: Thank you.