Confronting Demand's Downside

Fifteen months ago, as his company's 2001 fiscal year was just beginning, Michael E. Marks, chairman and CEO of Singapore-based Flextronics International Ltd., promised investors, employees, and customers that the best was yet to come. And in one sense he was right. Flextronics closed the year with a record $12.1 billion in net sales, a stunning 74% better than the $6.96 billion posted in fiscal 2000. But at fiscal yearend 2001 the company's consolidated statements of operations contained a charge Marks had not foreseen. For the three months ending Mar. 31, 2001, Flextronics, the world's second-largest contract-manufacturing firm, took a $276 million restructuring charge as it moved to cut production capacity by about 15% and head count by 10%. As a result of the charge, earnings in the final quarter of its 2001 fiscal year declined to 22 cents per share, 4 cents lower than fiscal 2001's third quarter. Flextronics expected to take a smaller restructuring charge -- projected at $10 million to $20 million -- in the quarter completed on June 30. Although the future promises good growth for many, the plain truth is that as U.S. capital spending has plummeted during the last several months, the cruel side of the law of supply and demand has been punishing Flextronics and other contract manufacturers. These companies make products for such name-brand OEMs as Cisco Systems Inc., Compaq Computer Corp., Hewlett-Packard Co., Palm Inc., and Motorola Inc. Flextronics' CEO Marks says he's "not particularly optimistic" about the level of business with existing customers and in existing products for the rest of this calendar year. "We didn't get through it unscathed." Flextronics is not the only company in the electronics-manufacturing-services industry, as contract manufacturing is formally known, taking restructuring charges. For example, industry leader Solectron Corp. recorded a $285 million restructuring charge for its fiscal-year 2001 third quarter, which ended June 1. Sales in the quarter were $4 billion, down 26.5% from its second quarter. And in sharp contrast to net income of $119.7 million in the third quarter of fiscal-year 2000, Solectron posted a $186 million net loss in this fiscal year's third quarter. A month ago Solectron said that if market conditions warranted, it would "consider further restructuring actions." Toronto-based Celestica Inc., at $9.8 billion the world's third- largest contract manufacturer, on Apr. 19 said it expected to take restructuring charges of $40 million to $60 million for the calendar quarter that ended on June 30. Celestica planned to consolidate facilities and cut its workforce by "less than" 10%. Meanwhile, down the ranks from the industry leaders, the revenue prospects aren't particularly encouraging at InnerStep, a San Jose, Calif.-based contract manufacturer for midmarket OEMs. COO Joe Beek figures that, not counting any gains that might come from acquisitions, his $54 million company's sales will be flat in the current fiscal year. Flat sales would be a stark contrast to the 38% sales increase recorded in the fiscal year that ended Mar. 31 and the remarkable 105% gain the previous fiscal year. Nevertheless, this does not appear to be the beginning of a permanent fade for the estimated 800 to 1,000 contract manufacturers in the U.S. and the 2,000 others elsewhere in the world. At least in the U.S., the trend toward outsourcing of production seems well established, particularly as cost-conscious OEMs continue to redefine or rediscover their core competencies. Indeed, Flextronics' Marks spoke as recently as two months ago of a "consolidation of business" from OEMs to top-tier contract manufacturers. And Douglas J. Tuttle, a partner in Deloitte Consulting and the Boston-based global director of its high-technology practice, suggests that the percentage of total production being done by contract manufacturers, variously estimated currently between 20% and 30%, might be on the rise. Such companies as Lucent Technologies Inc., Hewlett-Packard, and Compaq may "decide to go more toward the contract-manufacturing model" and "shed more of their manufacturing assets," he speculates. Caught Holding Inventory In contrast to the rest of manufacturing, which began showing signs of slower growth as far back as 1999, the high-tech sector of the U.S. economy seemed almost immune from a business slowdown until the first calendar quarter of this year, notes Richard DeKaser, senior vice president and chief economist at National City Corp., Cleveland. Then, four months ago, as DeKaser says, "the bottom finally did fall out." Business spending on infotech posted its first quarterly decline in a decade. "Contract manufacturers got stuck holding both works-in-progress inventory and finished inventory on their books," relates Thomas W. Petersen, president and CEO of ThreeCore Inc., a privately held, third-party procurement firm in Danvers, Mass. When consumer demand fell, "the contract manufacturer was unable to rally quickly enough to avoid being stuck with the inventory -- or to find another customer for [a] custom good," he says. The "recent swoon" in contract manufacturers' fortunes is due mainly to "the larger economic forces at work," believes InnerStep's Beek. And as he chronicles recent events, the crash of the telecom industry came first, followed by the consumer-electronics, semiconductor, and semiconductor-equipment market segments. Seemingly entranced by the lure of unlimited demand in the new economy and frustrated by a shortage of semiconductors and other electronic components that had been delaying shipments, big-name OEMs in telecommunications and Internet-related equipment last fall "got overly aggressive in ordering to assure themselves the quantities they [thought] they needed," adds Pamela J. Gordon, president of Technology Forecasters Inc., an Alameda, Calif.-based management consulting firm. National City's DeKaser sees the U.S. now in a kind of information-technology pause, a period in which the country is digesting a two-year binge of buying that, economic theory says, should have been spread out over three or four years. "In many cases," contends DeKaser, "IT products simply [have] not yet been fully integrated." For at least some of the 3,000 or so contract manufacturers in the U.S. and elsewhere in the world, this may be a pause that perplexes. But, according to several experts who closely track the fortunes of contract manufacturers, companies would be better off using the time to address three critical and related issues. To boost their longer-term performance, they need to focus on improving information, diversification, and flexibility. Flextronics' Marks acknowledges that as demand for telecommunications equipment and high-tech electronics began dropping late last year, the information flow from OEMs to contract manufacturers "was not very good." Marks faults human nature for the failure. Salespeople kept insisting they were still going to make their numbers. And sales-driven OEMs didn't want to accept signs that orders were slowing, nor did they want to pass on the information. They were, it seems, in a kind of denial. Petersen, ThreeCore's CEO, places the blame elsewhere -- on what he claims are serious management-systems shortcomings. While both OEMs and contract manufacturers want to talk about their kanban systems and inventory replenishment, "what they don't recognize is that they need to look . . . and make sure there actually is demand flowing through the entire supply chain," he claims. "We have heard a lot about investments in ERP systems and Web-enabled communications collaboration, but [the fact is] we're sitting here looking at the car wreck of inventory." Contract manufacturers and OEMs -- and anybody else who relies on them -- "have to understand that ERP systems are fundamentally flawed when it comes to driving material flow," he insists. "Contract manufacturers and their subsuppliers are going to have to deploy technology in the future, and [employ] sourcing techniques in the future, that allow them to signal to their suppliers based on actual demand -- as opposed to ERP push-style capacity planning." At the same time, if any single OEM customer accounts for more than 10% of total business, a contract manufacturer is jeopardizing its revenue potential and making the company less competitively fit, warns Kenneth D. Black, president and CEO of the Lean Manufacturing Group LLC, Nashville. What a contract manufacturer should be selling, he contends, is not the ability to be the best circuit-board producer, but its capability to be the best manufacturer in a broader sense. Its ability to develop anything the customer needs. To have the best engineering. To have the shortest leadtime with the best quality. "In order to do that, you have to maintain high customer diversification," stresses Black. At Flextronics, for example, no single OEM customer accounts for even 10% of total business, and maintaining a diversified customer base is something "we're always trying to do," says CEO Marks. Yet, diversification is more than a matter of limiting a single customer to a specific percentage of the business, stresses TFI's Gordon. To ensure a steady flow of new orders, contract manufacturers ideally need to serve four "cornerstone" markets -- and not tie their fortunes to one or two market segments, she says. Otherwise they are at "grave risk" of experiencing order cancellations when an electronics market segment falters -- as has the wired-telecom industry in the wake of last winter's dot.com collapse. Widening The Ledge In putting together their business portfolios, contract manufacturers, says Gordon, have 10 options from which to choose: auto electronics, consumer electronics, wireless communications, wired communications equipment, computer systems, computer peripherals, test equipment and other instrumentation, industrial electronics, medical electronics, and military and aerospace electronics. In addition, says ThreeCore's Petersen, there's "a huge untapped demand" for contract manufacturers that can make semiconductor capital equipment and other fairly complex electromechanical gear. "When you start stripping away things like telecom and consumer electronics [contract manufacturers] are operating on a pretty narrow ledge," he contends. If Flextronics is a good example, that ledge can become wider for contract manufacturers that offer more than just a production line for hire. A competitive advantage for Flextronics, brags Marks, is that the company offers a broader array of services than its competitors. In addition to producing boards, molding plastics, and building enclo-sures, "we have very strong design services [on the] front end and logistics management on the back end," he says. The hallmark of most contract manufacturers is that they are more flexible than their OEM customers, notes TFI's Gordon. A contract manufacturer, regardless of size, "will have more than one OEM customer and so will be able to balance levels of production and achieve economies of scale," she explains. However, because of different production equipment, software packages, and cultures, flexibility has been hindered "somewhat" as contract manufacturers have increasingly been purchasing plants from their OEM owners, Gordon states. "Some of the large [contract manufacturers] claim the transition period occurs in less than two months, which is astonishingly quick," she relates. Equipment and software can be changed relatively fast, she acknowledges. But "often cultural change takes longer," she stresses. Meanwhile, with newly purchased plants or not, contract manufacturers and their OEM customers continue to wrestle with optimal manufacturing mixes. In simplest terms, it's a matter of working out which manufacturer makes the high-volume, low-variable products and which does the high-variable, low-volume ones. "The contract manufacturer actually has to adapt to a more flexible manufacturing process, so it, in fact, can do the high volumes and also do the smaller volumes with high mix," says Deloitte Consulting's Tuttle. His bottom line: If contract manufacturers can increase the scope of the services they offer and do both high-volume and low-volume production, "they can, in fact, make pretty good margins."