BORN IDENTITY?
BenQ’s two-in-one business model has started to backfire, forcing it to make painful choices.
By Abe De Ramos

For Eric Yu, CFO of Taiwanese consumer electronics maker BenQ Corporation, the equation was supposed to work smoothly. Over the last three years, Yu spent over US$100 million in marketing to deliver BenQ’s brand of televisions and mobile phones across six continents. The amount is trivial compared with the fabled half-a-billion that Samsung Electronics is said to spend each year on advertising alone, but it’s no mean sum for a company that’s barely four years old. Although it’s been around for two decades as a subsidiary of computer giant Acer, BenQ became a brand only in late 2001, and until its marketing efforts start paying off, Yu relies on the company’s tried-and-true contract manufacturing business to keep margins on high ground. It took only two quarters for Yu to realize that the equation won’t always add up, and that BenQ may have to re-write it sooner than it had planned.

BenQ is nearly solitary in rekindling a two-in-one business model that had frustrated or daunted its peers in the past. Empowered by technological expertise, low production cost, efficient supply chain, and strong cash flow, many Asian original-design manufacturers (ODMs) have been tempted to top up their outsourcing operations with a higher-margin branded business, often to disastrous results. Acer, for example, bled for years trying to build a global brand name from the ground up, compromising its outsourcing businesses in the process, before eventually spinning them off. This example is often cited by the new breed of Asian ODMs that have found a shortcut to brand credibility by acquiring struggling or unwanted global names, from China’s Lenovo that bought IBM’s personal-computer business, to Hong Kong’s TechTronic Industries that now owns the once-Japanese Ryobi brand of power tools.

Making no secret of its desire to become the next big Asian brand, BenQ (pronounced ben-cue) insists the organic model can still work. “We’re trying to push the branded business to balance the ODM business, and the best percentage we’re looking at is 50-50,” says KY Lee, its aggressive chief executive who started his engineering career with Acer. Lee traces Acer’s failure to poor execution – it decentralized manufacturing so much that it was bogged down by costly logistical problems that then impaired its ability to deliver its branded products on time. (See box, “Lessons from Acer”) This will not happen with BenQ, Lee assures, because its production is centralized in a township-sized facility in Suzhou, west of Shanghai. “With that, we can better control our inventory and push our turnaround time,” says Lee. “All the products in the warehouses are fresh and are made at the most competitive prices.”

Yu adds that the days when contract-manufacturing clients worried about revealing their intellectual-property secrets are long gone. ODMs such as BenQ now practically own the entire product chain – from design to manufacturing to shipping – if not for the labels. In fact, says Yu, the savings that the company generates out of economies of scale from volume orders are invested in research and development for the brand, and the output and skills created from which BenQ can then share with its ODM clients. “The branded and ODM businesses gain mutual benefits from each other,” Yu says. “We don’t have to prioritize one over the other.”

LEFT IN THE LURCH

Yu may have spoken too soon. Until last year, BenQ was the largest handset ODM in Taiwan, shipping 16 million units – double the volume of its nearest rival Compal Electronics – to clients from Motorola to Nokia. As a high-margin business, the handset ODM served as its cash cow, giving BenQ enough juice to embolden it to aggressively position its products for a global market. Over the past year, BenQ wrapped taxicabs in Milan with its bright purple logo, sponsored Europe’s biggest football championship, and set up splashy booths in trade shows in Hanover and Las Vegas. Consumers took to BenQ’s stylishly designed products. BenQ’s branded sales steadily climbed from 24 percent of the total in 2002, to 29 percent in 2003, to 37 percent of last year’s NT$165 billion (US$5.3 billion). It is now predicting the 50 percent goal will be achieved this year – but not for the right reasons.

In an untimely move, Motorola, its biggest client, last December parted ways with BenQ and transferred handset orders to pure ODM player Compal. Three months later, Nokia was reported to have cut its orders for clamshell handsets, giving them instead to manufacturers in China. The latter represented half of BenQ’s estimated shipments of 10 million units this year. Analysts saw these as a clear indication that established brands have grown uncomfortable with giving business to a company that’s positioning its own products against theirs. “BenQ’s defense is they’re not competing directly because they’re in different market segments or geographies,” says Dominic Grant, analyst at Macquarie Securities in Taipei. “But if they really want to be the next Samsung, then eventually they will be competing with their customers.”

The exit of the big-volume clients was especially painful for two reasons. For one, BenQ’s customer concentration is heavily skewed: its top four clients represent 45 percent of revenues. Also, it’s a blow to the brand strategy. BenQ was poised to make handsets as its flagship product with which its name would be identified. Although it made products in three other categories – displays such as computer monitors and LCD-TVs, digital media such as laptop computers and projectors, and storage devices such as DVD recorders – it had invested heavily on high-end handsets. As a new entrant in a low-volume segment, BenQ needed the economies of scale from ODM to keep its branded-handsets business profitable. Losing Motorola makes it unlikely this year.

To make matters worse, the blow came just as BenQ was struggling in its displays business, which makes up half of total sales. TFT panel prices fell as much as 40 percent in the second half of 2004, and are projected to slide a further 20 percent by the end of June. As a result, BenQ’s net profit slumped by 90 percent in the first quarter of the year to NT$300 million from NT$3 billion last year, as sales fell 23 percent to NT$32 billion from NT$42 billion. Operating margins, the ratio of operating income to total sales, fell to a wafer-thin 0.1 percent from 3.7 percent last year. Not surprisingly, BenQ’s share price is now 11 percent lower than when the year started.

Analysts don’t see when or how BenQ’s fortunes will turn. “We don’t see any catalysts over the near term,” says Alison Yip of CSFB in Hong Kong, who forecasts another 50 percent drop in profits and 11 percent in revenues for the whole year. Some argue that the tide has turned for BenQ to reconsider its business model if it were to sustain its record of profitability. Given the loss of confidence from key clients in its handset business and the volatility of the TFT-panel market, the economies of scale that figure prominently in Yu’s equation have all but become unstable. To recover its margins, BenQ needs to manufacture in meaningful volumes, and analysts say BenQ should soon make up its mind whether to accomplish it from its contract-manufacturing business or from its own brand.

“BenQ is at the cusp of becoming a large branded business,” says Grant, who describes the company as being at an inflexion point between an ODM with brand ambitions, and a brand that also happens to have an ODM business. “History shows that it’s pretty difficult to maintain the two, so over the long term it will probably need to restructure its business to separate the branded and ODM businesses, although management is very resistant to the idea.” Adds Raymund Hsu, analyst at credit rating firm Taiwan Ratings: “They’re moving their brand in the right direction. It’s just a question of how fast they can increase their sales to a certain level that can allow them to have a profit. It’s going to cost them money and it’s going to take time.” In short, unless BenQ gives up one for the other, either business could be stuck in second gear for a long while.

TWO-FACE

To be sure, the past two quarters didn’t force BenQ to rethink its two-faced business model. On one hand, Lee considers its moribund performance during the period as a market glitch. He believes the bottom has been reached and expects shipments of its LCD-TVs, digital projectors, and Joybooks – its self-branded laptop computers – to be flat at worst in the second quarter, on their way to a recovery later in the year.

On the other hand, while the ODM business was set back by the loss of Motorola, opportunities lie elsewhere. UBS estimates that Taiwanese companies make up just 8 percent of ODM-built mobile phones, and analysts are certain BenQ will take a crack at this opportunity. Most recently, BenQ won a contract to make CDMA handsets for Kyocera, a Japanese brand, as well as mobile-phone service providers themselves such as Telecom Italia Mobile and Britain’s mmO2. More of the latter could be a potential growth area for BenQ. “It’s just in the very early stages [of tapping this market], so it hasn’t really established a real network with a broad enough product portfolio,” says Arthur Hsieh, analyst at UBS Securities in Taipei. “But operators are becoming an increasingly more important group of clients that ODMs cannot ignore.”

Although it’s unlikely that BenQ will spin off its ODM business in the foreseeable future, there’s no denying that the branded business has been thrust to the fore sooner than BenQ had planned. Lee acknowledges that the company has been under greater pressure to rely on the branded business to secure its future. “It’s become very difficult for the company to manage a sustainable growth for the ODM business,” he says, “so we have to develop our branded business to balance out the fluctuation.” To do that, BenQ will almost certainly have to increase its marketing expenditure. “Longer term, there’s definitely a viable branded business here, but to build a brand you’ve got to spend,” says Grant of Macquarie. With revenues weakened, this will strain its bottom line for the time being. “We believe it remains a challenge for BenQ to balance its initiatives of promoting a strong brand name and cost rationalization,” says Hsieh.

Over the last three years, BenQ has spent 2 to 3 percent of sales each for marketing and R&D. Jerry Wang, chief marketing officer, says during that time, the company has succeeded in creating brand awareness, particularly in Europe, which makes up 40 percent of its branded revenues. In the next three years, BenQ will begin to more aggressively break into the US market, which currently makes up just 15 percent of branded sales. Wang’s marketing strategy has also shifted from brand awareness to brand preference, in which the company will focus on enhancing the core quality of its products, to better compete for market share with its more established rivals.

“In the past, we tried to captivate the market with our designs,” says Wang. “We need to bring this to a whole new level, perhaps through some kind of breakthrough innovation.” For now, that largely means improving the interface of its products – a function of both external design and the software behind it – that it can launch in the next three years. “There’s still a lot of room for current products to become more human-friendly,” says Lee. Last month, BenQ opened an R&D center in India that will employ 100 engineers by the end of the year to develop more advanced software for its handsets.

For new technologies beyond the next three years, BenQ has a team of 30 scientists working on areas ranging from micro-electronic machining systems to nanotechnology to biometrics. BenQ currently has 2,000 patents (it generates about 400 a year) including what it calls SenseEye technology for displays, which adjusts the brightness and contrast of images depending on how much light from the room the monitors receive. BenQ’s latest product innovation, released in March, is an integrated mobile phone and MP3 player, an example of the digital-convergence trend for which BenQ is designing its products. “Most of the mobile phones today are very much phone-centric,” says Wang. “We’re making them application-centric.”

One significant change in BenQ’s strategy is to reduce the number of new models for each of its product lines. This makes financial sense, says CFO Yu. “Creating one model demands a lot of resources in terms of manufacturing and inventory cost, and since gross margins are coming down, we have to reduce our costs and the risk of inventory overhang,” says Yu. Being able to focus on a few products also increases its chances of hitting the market early. “It used to take nine months to one year to get a totally new handset out,” he says. “But now we have to reduce it to six months to nine months.” Fewer products will also make it easier for Yu to monitor the exact return on investment from each new item BenQ launches. A new product gets three years to prove its marketability before BenQ pulls the plug.

Analysts say BenQ could do more. While they’re impressed with its R&D, BenQ could improve its bottom line by reaching into a lower market segment, they say, that could give it the much-needed volume to enhance its margins. Some of its handsets such as the earlier P30 smart phone have received lukewarm response. “BenQ started to sell very high-end products even though the brand was still new,” says Hsieh of UBS. “It’s very difficult for consumers of high-end products to accept a new brand.”

In this respect, BenQ seems indifferent. Its latest line-up of products remain aimed at high-income customers, from 15-inch laptop computers to 19-inch computer monitors and wide-screen LCD-TVs. “We started with the middle high-end market, people who care for more trendy designs and better user interface,” says CEO Lee. “We hope they can influence other followers and bring up the product positioning in a bigger way. I think we have done that successfully in the first stage.”

Some analysts are also concerned that BenQ’s diverse product range may in fact be hurting its branding strategy. “BenQ seems to be doing everything, but it doesn’t have enough ‘star’ products like Samsung, which excelled first in cell phones,” says Jill Huang, analyst at CSFB in Taiwan. Adds Hsieh: “It could cause them to spend a longer time to build up a clear image.” With its mobile phone business impaired by lack of scale, Hsu of Taiwan Ratings says going forward, BenQ could anchor its brand on its TFT panels business. “For this product line, they can pursue both ODM and branded businesses at the same time,” he says, “because unlike big mobile-phone brands, these clients are more reliant on ODM suppliers.”

CAN'T TOUCH THAT

For his part, Yu says he has made it a finance-department priority to help improve operational efficiency – such as ironing out kinks in the supply chain – that could otherwise eat away margins. Analysts couldn’t agree more. “BenQ must know how to use its marketing expenses wisely, how to select the right products, and how to streamline overall operations,” says Hsieh.

Stung by an industry-wide oversupply of TFT panels, BenQ is now centralizing its demand forecasting in Taipei so that the overseas channels don’t keep excess units. Yu says the company is upgrading its order-management system towards a ‘no-touch’ inventory system. That means shipping customers’ orders directly from BenQ’s factories in Suzhou, without passing through its overseas channels’ warehouses. “Our earlier focus was to improve the quality of our products, but now that our branded business is growing, we’re building up our logistics capabilities by upgrading our systems,” says Yu.

Although directly shipping individual orders from Asia to customers globally will add to logistics costs, Yu says it will be more than offset by reduced inventory costs. The goal is to bring down the inventory cycle from 40 days to 26 days as soon as possible, and effectively accounts receivable as well. Alongside this, Yu is also transforming its relationships with suppliers by adopting a vendor-managed inventory (VMI) system. Under VMI, suppliers are given the responsibility for tracking inventory levels at BenQ, automatically replenishing needed parts or components according to predetermined levels – something BenQ would have already seen from its real-time ordering system.

“We’re making our systems more transparent to our suppliers so they understand our status and requirements,” says Yu. “That way, we can implement just-in-time component [procurement].” This may seem unnecessary given that BenQ has subsidiaries – including AU Optronics, the world’s third-largest ODM of TFT-LCD panels after Samsung and LG Electronics – that can practically supply everything it needs. But Yu says the company has made it a policy not to source more than 40 percent of its component requirements from them. “We want them to compete with other suppliers so they will keep on developing their own capabilities,” says Yu.

On top of this, BenQ is redrawing its relationship with channel partners, having been bitten in the fourth quarter when distributors demanded rebates that the company didn’t see coming. “One reason why their margin was below expectation was that requests for rebates didn’t really come until the last minute,” says Hsieh of UBS, “and by agreement, they had to pay them.” The rebates were especially burdensome given that BenQ also rewarded distributors according to gross sales. By the first quarter of this year, the company changed the incentive scheme to a percentage of net sales. As a result, despite a 20 percent drop in sales between the two quarters, the company managed to add 0.8-percentage point to its gross margin. It also generated free operating cash flow of NT$1.6 billion, and cut its cash conversion cycle from 32 days to 14 days.

“The company is prudent in managing working capital, and although we don’t see a sales recovery this year, this is one thing we feel comfortable with about BenQ,” says Hsu of Taiwan Ratings. The company has deep pockets, and Yu manages finances conservatively. As of the first quarter, BenQ had cash and liquid assets amounting to NT$11.9 billion, and long- and short-term debt of NT$6.75 billion. It has NT$26.7 billion in unused short-term credit lines, and by the first week of June, it was expected to raise NT$4 billion in bonds to repay existing debt while locking in currently low interest rates.

All these should help BenQ to sustain its vigorous branding strategy while it finds a new way to make sure that its own brand ambition won’t conflict with – and result in the loss of – its ODM contracts. Over the long term, a hint of where BenQ is headed can be gleaned from how CFO Yu would like investors to look at the company’s stock that, even in the good days, was undervalued relative to both its branded and ODM peers. “In the last three years, most investors had a big question mark on our branded business; they wondered why we were doing it,” he says. “We have to prove that we are pursuing a successful and sustainable branded business.”