FLEX TIME
Formerly high-flying Flextronics now has everything going against it. And its biggest bet, mainland China, could turn out to be its biggest headache.
By Jasper Moiseiwitsch

Something is eating at the heart of Flextronics. Nine years ago, the electronics giant moved its headquarters from California to Singapore to be closer to its low-cost Asian manufacturing base. The company embraced a new style of production called electronics manufacturing services (EMS), churning out products designed by global brand-name companies at low cost and high volume. It met with much success, becoming the world's second-largest EMS company after Solectron, making everything from Ericsson mobile phones to Microsoft X-Boxes.

Today, this model is under attack. Following US$731 million in losses over the past two and a quarter years, Flex's stock price fell so far that in July CEO Michael Marks hosted an emergency telephone conference call to reassure analysts that the company had adequate liquidity to survive. In the call, Marks moaned: "It is clear that investors do not understand what is happening with Flextronics."

A Contested Market

In fact, investors may already know what Flextronics' boardroom is only just beginning to grasp. There's a David and Goliath scenario brewing in electronics manufacturing in China, and Flextronics - once seen as a model of nimble production in the global marketplace - has yet to recognize itself as the lumbering Goliath.

The David - or more precisely Davids - in question are Taiwanese firms, mostly original design manufacturers (ODMs) that have moved into China and have encroached on Flextronics' territory. Taiwan's electronics industry, from power cables to semiconductors, has been decamping in its entirety to China over the past decade (see "Taiwan to China," July 2002). They are seeking the same cost savings as Flextonics and their successes in China have revealed weaknesses in the EMS model.

What separates ODMs from their EMS rivals is part geography, part flexibility. Most EMS companies are from North America; most ODMs from Taiwan. These companies have strong design skills and often present the large branded companies with original, self-designed goods. Branded companies just slap on their label and feed the product into their sales and distribution networks.

Flextronics is well aware of their existence, but not of the danger they pose. Says Robert Dykes, the California-based CFO of Flextronics: "The ODMs have moved to China to try and become more competitive with Flextronics... I think the threat isn't them against us, it's us against them."
That may be so, but something's gone a little wrong in big China. Research from Merrill Lynch notes that aggregate sales of North American EMS firms have fallen by a third since a December 2000 peak. Taiwanese ODMs saw sales rise by 11 percent in the same period. The implication, says Merrill Lynch, is that ODMs are taking market share from North American EMS firms.

Of all the contract manufacturers, Flextronics is most identified with China. It opened the country's first US-managed EMS plant, it has doubled its mainland plant space in the past two years, and today it holds more manufacturing square footage in China than all the other North American EMS firms combined.

Says Ash Bhardwaj, president of Flextronics' Asia Pacific operations: "We believe that, in Flextronics, it's all about China. If you want to play in our industry and you do not play in China, then you better get out of the way."

Flextronics has come to China for its growing domestic market and its cheap, plentiful labor. Hourly wages in China's electronics industry average US$0.60 to US$1, versus US$10 to US$20 in developed countries. Increasingly important, and the consideration most emphasized by Dykes, is the mainland's wide, deep manufacturing support structure. Other manufacturers make the power units, plastic casings, semiconductors, printed circuit boards, and so on, that Flextronics can call on for its own production needs.

A Case of Erosion

AFlextronics has bet big on this model, but the demand for it is showing signs of erosion. This is most apparent in low-end consumer markets, where the ODMs have been most successful. Cell phones, PCs, PDAs, digital cameras, printers and the rest have become so basic that branded companies see little competitive advantage in controlling these products' design and technology. For example, Intel and Microsoft own the most valuable intellectual property that goes into PCs. All other technology is sufficiently peripheral to outsource to the ODMs, which is why the Taiwanese dominate that market.

Flextronics seems particularly vulnerable to the Taiwanese in the mobile handset sector - its largest product category at 31 percent of sales. Branded cell phone firms have been increasingly happy to outsource cell phone production - including design - to the ODMs and focus on the real 'value added' of marketing and designing the software that powers these handsets. Nokia of Finland, for example, does good business selling its handset software.

Flextronics says that it gets a lot of questions about its competitiveness in the handset market vis-à-vis the ODMs, but answers that the ODMs haven't matched Flextronics' manufacturing scale or logistics abilities. "For all the noise around ODM cell phones, there are very few out there. There are a lot of companies that show them and talk about them, [but there are] very few programs where ODMs have been successful in any kind of volume of more than hundreds of thousands, or maybe a million here and a million there," says Marks.

But BenQ, a Taiwanese ODM and Acer spin-off, expects to make 14 million cell phones this year, about 80 percent of which will go to Motorola. BenQ reported a doubling of net sales in the first six months of 2002, and it is in the middle of a strong expansion in mainland China.

Tony Tseng, a Taipei-based tech analyst for Merrill Lynch, estimates that Motorola can save 10 to 15 percent more on handset production by outsourcing to an ODM like BenQ, versus an EMS operator such as Flextronics. The difference is design. BenQ has about 300 engineers working on its phones, who can handle circuit engineering as effectively as Motorola's US-based engineers, and for about one-third the salary.

BenQ CFO Eric Yu says that manufacturing, from procurement to assembly, contributes only about a quarter of the handset value. The rest, and certainly the higher-margin value, is found in design, where BenQ excels.

"Most IT products show a 15-20 percent yearly price drop. Let's say an EMS company manages a 20 percent gross margin. If they don't offer design, it's difficult to see how they can handle that price pressure from [improving] production alone," says Yu.

Flextronics has strong mobile phone design skills, responds Dykes, saying that this is the one area that the company offers a complete ODM product. However, Merrill Lynch's Tseng downplays Flextronics' abilities here. "The general manager at a PRC Flextronics plant told us that its so-called ODM offering has more to do with the fabrication process, how you can make phones more efficiently," says Tseng, adding that a real ODM offering includes circuit design work. "We have heard that some of the EMS firms are going to buy design companies, to position themselves as more of an ODM-type operation," says Yu. "I would say that R&D is not a one- or two-day issue, it's a long-term investment."

Kirk Yang, a Hong Kong-based director and head of hardware and components research with Salomon Smith Barney, says ODMs have made a smart move up the value chain. Contract manufacturers' abilities - procurement, assembly and distribution - have become very competitive and low margin. The only way forward, he says, is to go the next leg up to design, which still offers some differentiation and reasonable profits.

Design to Last

Chong Chiet Ping, a Singapore-based operations manager for Hewlett-Packard - Flextronics' largest client - says Flextronics needs to incorporate greater design skills in its service offering. "It is inevitable," she says. "If I were Flextonics, I would look at my competition and I would have a strategy to match them in their ODM abilities."

The problem for Flextronics is that design is very much outside its business model. It makes so many products and has so many clients, that its engineering talent would be severely stretched if it offered focused design on every good. What's more, its biggest clients would be less comfortable outsourcing to Flextronics - thus revealing production and design secrets - if Flextronics were simultaneously competing with its own self-designed product.

Says Boy Lüthje, a professor at Frankfurt's Institute of Social Research and a noted EMS expert: "If you ask contract manufacturers about their strategy towards ODMs, they will tell you that they are trying to acquire ODM capability. The problem they have is that EMS firms by definition don't do product designs. Their customers are worried about losing their designs to their manufacturers."
That bind is reflected in Flextronics' ambivalence about its design strategy. CFO Dykes, a laconic New Zealander who has been with Flextronics since 1994, emphasizes the company's design skills while affirming its EMS strategy. "We have 1,500 design engineers, and we do a considerable amount of product design. So there is a small piece of our business that you would say might compete with the Taiwanese ODMs, but it's a small piece of our business," he says.

Nevertheless, the ODM business model is showing more vigor and viability in today's markets. While ODMs are strong in consumer markets, which have been stagnant but stable, EMS players have focused on the telecom and IT infrastructure markets, which have been in severe recession. Flextronics in particular was hurt by the loss of a US$30 billion contract to make telecoms equipment for Motorola.

While the Taiwanese have focused on a select number of profitable product lines, Flextronics has gone the EMS route of being all things to all clients. For example, it has consistently lost money on its enclosures (the plastic and metal boxes encasing desktop computers, for example) and PCB (printed circuit board) businesses, but it won't close these operations because they are central to its service offering.

Going to Mass

While the Taiwanese have nurtured modest, organic growth, Flextronics has embarked on a massive, acquisition-fuelled expansion, nearly doubling its sales over the past two years. This fits the EMS strategy of creating mass to achieve economies of scale, but it has also left the company with disjointed and excess capacity. It has digested US$1.3 billion in restructuring charges over the past two years, mostly spent on unwinding unprofitable plants.

But even within the EMS model, the Taiwanese have shown a steadier hand at doing business in China. For example, Taiwan giant Hon Hai Precision has made huge pushes into China - with much success. Flextronics generates twice as much sales as Hon Hai, and yet Hon Hai is profitable and Flex clearly isn't. Hon Hai is on a roll, consistently surprising investors with better than expected revenues and profits. The company has expanded smartly through the post-2000 tech recession and it is often identified as Flextronics' enemy number one.

"Flextronics is not as dominant in China as Foxconn (Hon Hai's consumer name)," says William Ozer, Nortel Networks' Hong Kong-based vice-president of supply chain operations. "They get a lot of support from Taiwan... financial as well as know-how. I don't know if Flextronics has the ability to enjoy that," he says.

Hon Hai is a vertically integrated EMS firm that makes Apple's iMac and Sony's PlayStation 1, among many other products. It is known for its strong mechanical tooling skills, employing 3,500 tooling engineers including 1,000 designers. Sharon Su, a Taipei-based analyst for UBS Warburg, says Hon Hai used its tooling abilities to focus on PC enclosures.

Their business grew smartly during the mid-1990s PC boom, and the firm became the dominant producer of enclosures. Because enclosures are the bulkiest item of the PC, it is easier to send components to the enclosures maker than vice-versa. For this reason, branded companies let Hon Hai become their main outsourcing agent, which has given it excellent pricing power for items such as disk drives and power supplies.

Su says Hon Hai also leveraged its lock on the enclosures business to capture other parts of PC manufacture, such as I/O connectors and cable assemblies. In the process, Hon Hai has become a fully vertically integrated EMS with lots of profitable bits added to its many points of production. It remains the model to beat, and company chairman Terry Gou says that Marks once returned from a Hon Hai plant visit saying that he wanted Flextronics to be as vertically integrated as its competitor. Flextronics' massive industrial parks in China, where it invites suppliers to co-reside with the ompany, reflect that strategy.

The difference is that Hon Hai largely owns and profits from its many points of production, and has tighter control over its internal supply chain. Hon Hai has also squeezed a lot of profitability out of its components businesses, while Flextronics has largely lost money here (read: enclosures, PCB). Hon Hai is also bigger than Flex in China and has better captured the cost and supply chain advantages of that market - Hon Hai has triple the number of workers in China as its US rival. Finally, Hon Hai has been more aggressive than Flex in controlling costs. For example, Flex air-conditions its factory floor space - at great expense - while Hon Hai does not.

Dykes says his company is well aware of the challenge posed by Hon Hai, but he says Flextronics is bigger and better positioned. "[Hon Hai] is very large in China, and a strong competitor. But we also have a very substantial operation in China... We have all the capabilities they have, and we can certainly go toe to toe with Foxconn in terms of pricing," he says.

All in the Family

TPart of Taiwan's success in China lies in its ability to control costs. Taiwanese firms go into the more peripheral parts of China where labor is cheaper and officials are more compliant. But beyond this, the Taiwanese excel at navigating China's political system and business culture.

When Flextronics' CFO Dykes is asked what concessions (tax breaks, cheap land, et cetera) his company has won on the mainland, he says his company avails itself of the usual deals granted foreign operators. "We've been able to take advantage of tax holidays. But that's all well documented within their laws. So we are not having to rely on relationships [to win concessions in China]," he says.

To the Taiwanese, those words might sound naive. Frank Lin, CFO of Wistron, a Taiwanese EMS operator that recently won a slice of Flextronics' jealously guarded X-Box contract, counts many instances where relationships matter in China. These include speeding up customs applications to buying land and managing operations costs. "If you want a piece of land to build your factory [in China] you will think okay, we will fix the price of the land," says Lin. "But in China there is a lot of regulation. They charge fees for permission to build," he says.

"Even more than that, you may need to work with a local [construction] company, and sometimes this is founded by the local officer, and you will have a headache. The price of land is maybe ten, but if you build a factory and put in all the equipment, the price may be 1,000," says Lin. Relationships help control those costs, he adds.

Alfred Chow, the Hong Kong-based CFO of EMS operator Karrie Industrial, adds that contract manufacturers keep a "team of specialists" to manage crucial relationships with China's customs officials. EMS companies depend on a fast, efficient supply chain, which can come undone if customs officials don't see things your way. "If you don't have a good relationship with the local government, then you can't stay in China," sums up Chows.

Whither Flex

The evidence suggests Flextronics has been through its worst. Its share price is up 59 percent since its July conference call. While it is miles away from the kind of credibility and investor confidence it had during the tech boom years of the late 1990s, it seems to have come through the latest recession with a reasonable business. In May, it announced a three-year US$2 billion outsourcing agreement with Casio, which positions Flextronics in Japan - one of the highest growth markets for outsourcing.

The recession has helped the firm consolidate its number-two position in the EMS rankings, as it has steadily bought businesses and seen others go bust. It retains all the qualities of being a tier-one EMS player: excellent sales ability, a global manufacturing presence, great logistics, good capitalization and the scale to reliably take on large-volume production.

Flextronics is also ahead of its rivals in relocating to low-cost countries. The largest EMS company, Solectron, only has 30 percent of its production in low-cost countries. It is looking to double that, and is starting to incur the huge restructuring costs this involves - Flextronics has already done this and has absorbed most of the charges.

The question is not so much whether Flextronics can compete within the EMS space, but whether it can match the Taiwanese in China. Flextronics has rightly put China at the center of its growth strategy. But its mainland presence has invited comparisons with the Taiwanese, who seem to have the momentum in terms of profits, growth and strategy.

Flextronics will have to live up to the flexibility implied by its name to grab that momentum back, or like Goliath, learn the hard way that size and scale won't necessarily carry the day.

Jasper Moiseiwitsch is a contributing editor at CFO Asia based in Hong Kong.