MarketWatch Commentary

EMS companies have been faring well, relatively speaking, and the strategic moves to diversify into new markets with important core capability links has analysts and market researchers generally more bullish than conservative. 

What is particularly interesting, as we continue to watch the ongoing EMS-ODM turf war (cf. MarketWatch Quarterly Vol. 1:1, "EMS/ODM a Mixed Market;" and Vol. 2:2, "Co-Evolution and Organic Growth"), is the varied strategies EMS companies are embracing.  As well presented in the latest MMI (Vol. 20:1, pp. 1-4) report, some EMS companies are following a new, retail path (e.g., Hon Hai's retail outlets); some are expanding to sister industries (e.g., Jabil's venture into solar panels and medical disposables); some are supporting new supply chains for the still fragmented clean/smart technologies (cf. the latest MarketWatch Quarterly Vol. 3:4, now available to subscribers and next week to the public); and some are engaging in more traditional M&A deals to expand their market reach and capabilities (e.g., Celestica's acquisition of Invec Solutions, as reported in MMI Vol. 20:1, pp. 2, 7).

Among the other trends forecasted by market analysts, we should see a resumption of more normal consolidation numbers for small- to mid-sized companies, renewed momentum for regionalization/localization (cf. MarketWatch Quarterly Vol. 2:3, "An Expanding European Microcosm" for more discussions on localization), and continued distinctions between EMS and ODM businesses but with increased "credibility to a hybrid strategy" (MMI Vol. 20:1, p.4).

The next one to three years hold promise for the EMS sector, and based on early analysts' reports for 2010, the new market opportunities may provide important growth for EMS in directions beyond the past 'turf wars' with ODMs.

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EMS for Europe has been very important, and therein are found some significant opportunities.  EMS forecasts are not stellar though (as reported in Manufacturing Market Insider (Vol. 19:11, November 2009) and citing forecasts from InForum market research).   Growth has started for EMS worldwide and looks to hold steady around the 5% range +/- from 2010 through 2013; it's just going to take three years to recuperate the losses from 2008-09. 

The lag in an EMS rebound needn't be seen as negative for Europe though; growth is growth, after all.  With EMS rebounding, albeit slowly, and Europe being heavily invested in EMS, particularly specialty or niche markets, there are noteworthy opportunities for European EMS to lead in new markets and sectors.  These opportunities and markets will be explored more closely in the upcoming MarketWatch Quarterly edition due out later this month!  Subscribe here to get your copy before public release.

The EU reaffirmed it's commitment to green policies at all levels during the UNFCCC's COP15 conference in Copenhagen, Denmark in December (see here for our commentary from COP15).  While that makes for nice political talk, it does have bearing on business markets, particularly semi.  One of the important ways in which Europe continues to be a world leader is in the consumer purchase power of highly efficient appliances and consumer electronics products. 

European governments are now providing reduced or no taxes on electric cars (meaning up to 180% reduction in high tax countries such as Denmark).  Couple this incentive with eager consumers for smaller, greener autos in light of the European auto sector having a better footing than, for example, the American auto sector, you realize quickly that there is ample opportunity for European auto to lead the global electric vehicle market.  Electric vehicles are an important market for semi, moving the percent of chips per vehicle significantly higher than traditional autos.

Will European semi rebound?  That's an interesting and very important question for many companies and for both the semiconductor and electronics industries.  There is vacillating investment in Russia, there are politico-economic reasons (see above) to believe new markets hold opportunities, and there is existing consumer support for products.  Although the pace will be staid, don't they say, "slow and steady wins the race"?

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As 3Q09 reports begin to trickle in there are positive indicators that indeed, the recovery is upon us, though no one is expecting a spike that is sustainable just yet. With the retrenchment of so many along the supply chain to reign in inventory numbers, protect margins and safeguard company health, there were also the opportunities for acquisition, mergers and JVs, as discussed here and here in earlier MarketWatch Commentary posts.

In sum, both the EMS and ODM sectors are down in double digits YoY, but ODMs appear to be doing better overall, as nicely summarized in Manufacturing Market Insider's recent September 2009 issue (Vol. 19:9, pp. 1-6). 'Doing better' doesn't mean positive numbers just yet, rather, not as down as EMS. "Large Taiwan-Based ODMs" are down -9.9% for 1H09, while the "largest EMS providers" were down -19.2% for the similar time period, including Hon Hai in the group (MMI 19:9 p. 3, 1); without Hon Hai, the decline would be -27.1%.

Why the difference between ODMs and EMS? One critical variable is the inventory realignments. EMS companies certainly felt considerable stress from both sides of their supply chains as inventory management issues left many EMS companies with difficult strategic decisions: working with OEMs and their downstream channel partners simultaneously, both of whom wanted inventory off of their books and docks. ODMs too felt the pinch this year, but of course with new market demands from consumers and OEMs having to reconsider margins, redesigns and innovative designs are in demand.

Those EMS companies faring the best, most notably Hon Hai, continue to do so based on "blue-chip" customers, diversification (i.e., not being a pure-play EMS) and supporting subsidiary units that can contribute and off-set other units' downturn periods. As MMI notes, though, one question about the outlier, Hon Hai, is whether it can continue to be considered an EMS or will it become more of a conglomerate? (ibid., p.3).

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Taking a close look at Citigroup Global Markets' recent briefing, Electronics Supply Chain Inventory Update (10 August 2009), the Supply Chain for the semiconductor industry is healthy, overall.  According to the briefing, days of inventory (DOI) averaged across the entire supply chain sub-segments are now down to the healthy low 40s (now at 43 days y/y which is good for this period based on long-term trends).  "Storage, Semis, and Servers/Enterprise post[ed] the most robust improvements y/y." (Citigroup 8-10-09, EMS Industry Brief, p.1)

Not all sub-segments were improving; DOI "for passive companies declined [...] to 93, [they] remain above [...] a five-year historical average of 84 days" (ibid, p.1) along with negative trends for "Telecom Equipment and Semi-Cap Equipment." (ibid, p.2)

Citigroup recommends closely monitoring three "critical factors": (1) Demand Seasonality - currently forecasts are strong and expecting growth "driven largely by Telecom Equipment, PCs and Semi-Cap equipment" (ibid, p.3); (2) Utilization Rates - with more normal patterns emerging and close watch on utilization upstream, "supply chain companies [look] to be able to better manage utilization rates and cost structures" (ibid, p.3); and (3) Pricing Pressure - this area is becoming 'more severe' and therefore Citigroup cautions, "we are concerned that pricing pressure could actually become more acute in the near term as suppliers compete for orders and market share in order to push up utilization rates and incremental margins." (ibid, p.3)

In short, with a good back-to-school season forecasted coupled with inventory de-stocking completed, chip sales should remain positive across the aggregated electronics supply chain.

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MMI's numbers show that M&A, inclusive of consolidations, were down by roughly 80% YoY!  Yes, that is indeed a historic number.  To simplify, general analysts' consensus is that during economic downturns consolidations tend to rise as a result of cash-strapped corporations looking to increase margins, move capabilities back in-house, and/or simply find alternative ways to stave off insolvency or to make a market move for future expansion and market share increases by acquiring capabilities during a fire-sale.  This just didn't happen, despite what we all thought!

Interestingly, cash savings and murky outlooks seem to have been so much at the fore that even the opportunity to buy while the buying was good proved to be too risky for most.  Moreover, the historic downturn in 1H09 breaks a long-standing EMS/ODM market trend of regular M&A activity in order to increase or expand capabilities. 

As MMI notes, the lack of M&A activity in light of the EMS/ODM trend "[...] indicates that in the business climate of the first half some providers either elected to put off acquiring a new capability or decided to develop it in-house instead." (MMI, Vol.19 No.7, p. 2) 

So, what was up?  Joint ventures (JV).  Why?  Well, JVs tend to cost a lot less but come with limited risk exposure for a comparable gain in access to the desired assets or market (ibid., pp. 2-3).  Of note: MMI does not include EMS divestitures that are not retained in the EMS sector which could skew the data (ibid., p.3).

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Don't expect a long line of shopper's waiting to buy though, Reuter's adds that Richard Curtin, survey director, cautioned that"while consumers believe the economy may have hit bottom, most consumers believe that when the rebound starts the economy will gain ground very slowly. [...] Consumers' financial situations remain dismal as the majority reported that their finances continued to worsen."

Inventories seem to still be managed well across most major market sectors, semiconductor included!  Manufacturing is still contracting, though at a slowing pace, according to Kathy Lien, Director of Currency Research at FX360, "the [manufacturing] sector is crawling back towards expansionary territory.  The worst may be over but it is still far to [sic] early to label this a manufacturing sector recovery because factory orders fell more than expected in March."  Regarding that critical variable, inventories, Lien added, "Inventories was the only component that declined but this is positive because lower inventories means that companies may have to restock soon."

What exactly has been happening to the electronics manufacturing sector?  Well, I've discussed the inventory, IC ASPs, and book-to-bill ratio issues in short throughout this MarketWatch Commentary section and at length in MarketWatch Quarterly over the past many quarters here.  But if we look at where growth is within the EMS sector, as reported in Manufacturing Market Insider's latest April edition, "the four segments typically identified as nontraditional [industrial, medical, automotive, defense and aerospace] together with the miscellaneous category grew faster last year than the industry overall."  See MMI's newly released chart below (from MMI Vol. 19, No. 4, p.4) for their well supported breakdown of the EMS sector:

As MMI notes, while it is not surprising that nontraditional sectors show growth over mature sectors, it is interesting to see where this growth is happening.  Taken together with other metrics, more pieces to the industry's future can then be put in place.

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In the middle of the month, DigiTimes 4/15/09, released some good news about 3Q09 foundry sector growth to come because of orders from netbook and 3G handset makers.  Despite Nokia and Sony-Ericsson's slumping 1Q09 earnings calls, drilling down into the MID, smartphone and 3G subsector, we come to a likely source of the mobile market driver and the better news.

A great example of such a source is the SanDisk earnings call transcript from 4/21/09.  Herein we find some important information underscoring the positive impact that MIDs and their product cousins are having along the supply chain (check out this ZDNet blog for more commentary).  According to Dr. Eli Harari, Chairman and CEO of SanDisk:

In the second half of this year, we [at SanDisk] expect demand for NAND to continue to grow particularly for mobile and portable computing platforms and this should hopefully absorb the industry supply growth projected for second half. [...]

As for demand creation, I believe that the handset business is being transformed on a scale similar to that which the web experienced in its early days and this has far-reaching implications for our mobile storage business.

That's great for the component specific side of the coin, but what about the rest of the mobile device? The mobile OEMs are also transforming, now favoring ‘insourcing' as bell weathers like Nokia reverse course to reduce cost and improve profitability.  According to a report by iSuppli's senior analyst, Jeffrey Wu, "Nokia in 2008 decreased the percentage of its outsourced manufacture volume to 17.1 percent, down from 21.5 percent in 2007.  This reflects a larger trend in the mobile-handset supply chain."

iSuppli's Wu has a new white paper that looks more closely at "the fatal pitfalls in wireless handset outsourcing."  This is an important read because the relationship between OEMs and CMs is certainly changing and the supply chains are changed by the present market forces.  These types of supply chain changes are also explored in more detail here.  Certainly, it's not business as usual - as if we didn't already know that.  But knowing why is different than knowing what.

It'll be interesting to see what the decrease in outsourcing will mean to the ODM-EMS turf wars as we continue to walk through the new territory of 2009.

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Two other important data sets came out last week: Semiconductor Industry Association's (SIA)  February worldwide chip sales, and Manufacturing Market Insider's (MMI) final 2008 growth rates for the EMS sector (in MMI Volume 19, No.3).

SIA's numbers confirm what we've all felt: worldwide semiconductor chip sales were down 30.4% (US$14.2 billion) year-over-year (YoY).  This is a significant decline from January's 7.6% decrease YoY, but continues to be part of an ongoing correction in our industry, as well as in most global industries.  According to George Scalise, President of SIA, "while it would be premature to conclude that the sales decline has hit bottom, there are some indications that the rate of decline has moderated from the final quarter of 2008."

MMI's data are more positive, though only in the context of the recent severe macro-economic crisis we're going through.  MMI recently published (in MMI Vol. 19, No.3) their yearly survey of the 50 largest EMS providers worldwide (companies with a minimum of US$209 million in sales in 2008).  On the bare face of the data, we should be celebrating, as this group showed impressive sales of US$158.5 billion, or growth of 14.6% YoY.  Yet, as MMI astutely cautions, there are confounding variables that significantly lower this number:

1. Flextronics 2007 sales of Solectron; considering these data, the total 2008 growth is lowered by almost half to 7.7%;

2. The "Hon Hai Effect" - Hon Hai Precision Industry, the largest EMS provider, accounted for 39% of 2008 sales; adjusting for this effect by removing the Hon Hai sales, further lowers the 2008 growth rate to 1.4%.

While 1.4% is not a number we want to hear, it is realistic and rings true.  Importantly though, even this slight positive growth speaks to the ability for the EMS sector to grow in one of the worst cycles our industry and global economy has seen.

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