Chasing EMS value with low-volume / high-mix

Over the past few years, I've worked with a number of OEMs looking to strengthen positions with their electronics manufacturing services (EMS) and original design manufacturing (ODM) partners. (See, also: "When outsourcing is not the answer") I've also worked with several EMS companies (ranging from $15 million to $500 million in revenue) looking either to acquire additional EMS assets or wanting to improve customer acquisition success rates through better business development and more focused market differentiation strategies. A number of private equity firms plus some hedge funds have also sought out engagements - each wanting a piece, or knowledge of, the EMS space. While there remains good money to be made by the investment community in today's EMS market economy, the same can't really be said for what I sense to be the majority of EMS companies. Many are struggling to survive against a market strategy that's ill-defined at worst and lucky at best. (Read: "The wrong message: EMS value propositions still rooted in cost reductions") Whether your firm is an electronics brand-owner (e.g., OEM), an EMS / ODM company or, you're part of the finance community...if you have shareholders or investors then driving near- and long-term shareholder value is a common challenge you're facing today. For some time now, sales at most EMS / ODM companies have been contracting. Local, regional, and national economies across the globe can help explain contracting sales. (Read: nobody's buying) However, like all down cycles, this downturn we're currently in will correct itself. Worldwide EMS / ODM industry annual revenue growth rates 2005 - 2013 But, an economy-based explanation (or excuse) though can be explained, will undoubtedly not be deemed the root cause for those EMS / ODM companies that won't be able to come out of tailspins once international, national, and local economies steady their footing. For many EMS companies, sales contraction is their own making. All too often, I have seen EMS firms keep their eye on near-term sales growth...almost to the exclusion of other important strategic components of their business / industry sector, only to see an immediate rise in revenues offset eventually by lack of real industry knowledge and no real strategic direction accompanied by devastating declines longer term. Meanwhile, despite the economic slowdown across most, if not all, electronics outsourcing industry segments, automotive electronics (yes, automotive), medical electronics, defense, and industrial electronics seem to be some of the best bets for EMS  companies to make money in today's market and, moving forward. Margins are also typically better, even great by some standards. However, just growing low-volume / high-mix operations is not enough to secure higher margins. Calculated risk "Companies must be able to address greater risk as order volumes fluctuate, often greater quality requirements, and more dexterity in operations management", says Michael Palma, IDC senior research analyst electronics manufacturing services and consumer device semiconductors.  "Another aspect is many of these OEMs are less mature in terms of outsourcing and require more assistance and guidance from their partners, which eats into profits" he adds. Worldwide EMS / ODM automotive segment revenue forecast 2005 - 2013 The automotive segment has been hit hard by the global recession, as end-market demand for new vehicles has been crushed. Meanwhile, ODMs have gained traction in this segment through the increasing popularity of infotainment devices, especially after-market navigation products. Worldwide EMS / ODM medical devices segment revenue forecast 2005 - 2013 "Tighter finances, greater scrutiny from health insurance and other payer organizations, and other factors will combine to limit end-market demand in medical devices segment", say IDC's Palma. "At the same time, OEMs are increasing their use of contract manufacturers." In looking at this segment of the industry more closely, the medical devices market seems to be approaching a tipping point at which OEMs are becoming quite comfortable using tier 1 EMS partners for complete system manufacturing, and not just smaller, specialized firms for component and subsystem assembly. Worldwide EMS / ODM industrial segment revenue forecast 2005 - 2013 According to IDC, the diverse industrial segment which includes aerospace, defense, semiconductor capital equipment, and other industrial applications for electronics, is well suited for EMS firms that can deal with the unique requirements and generally low production runs for most equipment in this segment. The rate of outsourcing in the above segments also exceeds the overall rate of outsourcing on a compound annual growth rate (CAGR). Unlike consumer electronics, with its much higher growth rate and even higher volumes (which, by the way, has comfortably secured the consumer electronics sector the heavyweight title holder of the single most competitive segment of the EMS / ODM industry) the consumer electronics industry is suffering broad margin compression on the EMS / ODM side that, by some figures, is more than 2x the rate of EMS margin compression seen in the industrial, defense or medical electronics sectors. Its not rocket science to see this creates tremendous margin pressures on EMS / ODM companies heavy in consumer electronics. Focus, focus, focus One of the most widely held beliefs of many EMS / ODM companies I've talked with is that everything will get better if the company can just accelerate its core segment growth without making other significant strategic changes that should be addressed to create real shareholder value. For EMS / ODM companies already focusing on low-volume / high-mix EMS, one potential issue with this approach is "these are generally smaller contracts, with more OEM customer programs, so the EMS partner generally has greater sales and client management costs, which also erode margins. While margins are greater, costs and risks are also greater, so EMS firms need to price services commensurate with these costs and risks", says Palma. But, EMS / ODMs desperate to grow business in these areas may buy contracts by low-balling OEMs to win contracts. While this helps with short-term wins, "If providers cannot service the accounts and provide real value to the OEMs, this can become a lose-lose situation", he adds. EMS / ODM companies must focus on issues that have the greatest impact on helping organization create short- as well as long-term shareholder value. Companies should look to targeted sectors where they can provide real value to their customers. One company doing just this is Bentek Manufacturing, Inc. (www.bentek.com), a San Jose-based EMS provider run by chief executive officer Mitch Schoch, a former executive with Solectron (Solectron was acquired by Flextronics). With 100 employees, Bentek earned $35 million in revenue in 2008 serving such end-markets as semiconductor capital equipment, defense related as well as solar. However, managing low-volume / high-mix operations is different from managing high-volume / low-mix operations like, for instance, consumer electronics. "It's much, much different", says Schoch.  "The difference [vs. consumer electronics] is that the volatility of demand can be much more extreme. When markets are down people stop spending. We tend to see much more dramatic declines in demand in some markets, and particularly, things like semiconductor manufacturing. Whereas, on the flip side of that, when markets tend to come back, the growth is just absolutely explosive." EMS companies wanting to serve low-volume / high-mix sectors must be prepared for managing a lot of customization in their operations. But customization creates even more complications when the EMS provider is building product for various countries due to country-specific issues. Not to mention there's a far greater number of SKUs and variability of custom parts. Schoch says Bentek spent most of 2008 on improving continuous manufacturing, 5S, and quality to help meet these types of challenges. He goes on to say "a killer in this business is not managing your inventories tightly. We prepared for this downturn because we took a lot of actions last year to reduce inventory; limit buying of new inventories and limiting our exposure to potentially obsolete parts." In addition to medical and industrial electronics, another sector gaining interest among EMS business development section heads I've talked with includes the post 9-11 world of security which can immediately enhance sales development strategies for many EMS companies in our New World. EMS, ODM, and OEM organizations must move away from the easier path of focusing on the same or existing customers and markets if they want to survive. One of the most attractive opportunities for revenue growth and for clear profit margin out-performance in the EMS sector is in low-volume, high-mix, high complexity products for the middle market. Many, if not most EMS providers (even the tier 1), seem to focus on volume products, including consumer electronics. However, many Western OEMs with $10 million to $25 million in total available market (TAM) do not have access to low-cost, well-managed EMS work in this space. To be successful, well-done high-mix, low-cost EMS work requires strong process engineering, good systems and infrastructure, and experienced management talent. Many EMS companies, particularly in low-volume / high-mix are continuing to lose money, consolidate facilities, and in some cases, while they're restructuring to try to address the cost issues in their business, they're facing relatively significant challenges to their ability to perform, particularly in the industrial and defense-related sectors. As the EMS industry continues to become more commoditized, with many EMS companies who had their contribution margin priced in in order to drive volume during the periods they have expanded, many of these EMS players are now finding themselves reeling in the face of this market contraction and seeing some significant losses because of the aggressiveness in how they approached the market years prior. One EMS service provider that seems to be navigating these type of EMS management potholes fairly well Sypris Electronics, part of Sypris Solutions (www.sypris.com). Much like Bentek, Sypris focuses primarily on highly complex, and in some instances even higher reliability type applications. Sypris has roughly 380 employees and last year brought in $120 million in revenue against military and aerospace contracts for aircraft-type, land and sea weapon systems applications as well as electronics for satellite and spacecraft applications. The Company's narrow focus has helped it survive. But the defense electronics sector is not immune to challenges and is even undergoing some industry-specific changes of its own. There are different segment levels to the military defense and aerospace low-volume / high-mix EMS market. There's the lower-end, commodity segment which does not have a very high cost of materials and can also be done overseas (provided a technology assistance license can be obtained). Some of the providers in this low-end segment can clearly be defined as mom-and-pop shops. Others are much larger. "We've seen a lot of typical, commercial-type manufacturers enter into the low-end of the EMS defense market thus driving a significant compression in the margins there, driving some of the defense circuit card assemblies to, what I'll call, a commodity space", says Sypris Electronics president, John Walsh. Additionally, some of the manufacturers in low-end EMS, especially in the commercial aircraft segment, are even getting to a point where, "They are utilizing commercial practices in the purchasing process to the degree where companies playing in this low-end segment like Goodrich (www.goodrich.com) and Hamilton Sundstrand (www.hamiltonsundstrand.com) are pushing these types of circuit board assemblies and box builds offshore", he adds. Not to worry, says Walsh, "These kinds of components and assemblies are not vital from a technology standpoint. They're old technology." Meanwhile, Sypris leans toward the other end of the spectrum: high-end printed circuit boards with a much higher percentage of material content, perhaps for good reason, given the competitive nature of the EMS industry. Walsh points out that as EMS providers move from the lowest end (where the commodity aspect is) where EMS providers can begin possibly thinking about going offshore (and where the mom-and-pop shops can step in and build or, where the commercial guys can come in and start to play) the value chain requires a significantly increased complexity relative to program management; supply chain management, intellectual property associated with how the EMS provider actually puts things together, plus engineering support. This EMS business for low-volume / high-mix defense and aerospace work is causing some difficulty for some EMS providers, however. Walsh goes on to say that many of the top U.S. defense prime contractors, companies like Boeing; BAE Systems, Lockheed Martin, Northrop Grumman and General Dynamics, to name a few, are having a difficult time locating EMS providers who have the infrastructure to reliably execute when it comes to doing more complex box build and systems integration and assembly of sub-systems for the end customer, the U.S. Department of Defense. Indeed, many EMS companies, including most of the larger players who are caught up in today's market contraction because of contribution margins priced in to get to commodity pricing, basically have stripped their overhead that's required to do the more complex box-build, and assembly work. Put another way, "[Tier 1] EMS firms attempting to increase their business in low-volume / high-mix segments run the risk of undercutting their own investments, if their business models, decision making paradigms, and strategies are not aligned to serve these types of contracts", says Palma. Sypris' Walsh says, "And what the primes are finding is the likes of Celestica (www.celestica.com, also, read interview with Celestica's CEO), Spartan (www.spartanelectronics.com), and [similar EMS providers] that...because they've really tried to drive commodity pricing into [their business], [they] have had to cut so deep they don't have the ability to deliver anymore." When done correctly, low-volume / high-mix EMS models can yield considerable operating margins and even possibly help EMS firms create a market niche that can be defended. However, the work is not easy which is why it presents above average profit potential for those that can make a name for themselves. "We're just trying to capitalize on the situation", he adds. VentureOutsource.com, July 2009