Contract Manufacturers are
Wall Street Darlings

But growth isn't the only thing analysts track

By Jennifer Read

How can you argue with 40% annual growth rates? And return on invested capital
rates (ROIC) that average 20%? Numbers like these have led Wall Street analysts
like J. Keith Dunne of Robertson Stephens to recommend electronic manufacturing
products and services companies (EMPS) to investors, resulting in EMS stocks
outperforming the market in the third quarter for nine consecutive years.

Investment capital is the lifeblood of an industry; consequently, the financial
community plays a big part in many business decisions in the electronics
manufacturing world. Asset management tools and financial modeling
techniques are used to evaluate whether an OEM customer in the telecom or
PC market should outsource manufacturing or not. These decisions in turn
affect all the other players in the supply chain, including many of the readers
of Wiring Harness News who are contract manufacturers, or are suppliers
to that industry.

Investment banker and financial analyst J. Keith Dunne of Robertson
Stephens has been tracking the industry for nearly a decade. He divides
the companies into those that provide mainly services and those that are product-
based, selling power systems and printed wiring boards; a third category is
enclosures, defined as metal-based housings that facilitate systems integration.
According to Dunne, this category can be either product-based or services-based, depending on the company: enclosure manufacturers can range from companies
that fabricate metal and plastic housing to solution providers that offer sophisticated
engineering and design services. Dunne believes this category will merge with
the services providers eventually, but sees benefits in tracking them separately
at this time.

The total world market for the services sector, according to Dunne, is $90-100
billion. At this time, he estimates that 14-16% is outsourced; in 3-5 years, he
predicts 24-35% will be outsourced. In the products sector, he sees a total world
market of $37-39 billion for PWB manufacturers and another $18-20 billion for the power systems manufacturers. At this time, power systems contractors have
60-65% of that market; in 3-5 years they will have 80-85%. But the market for
PWB contractors is fairly well saturated; Dunne estimates that 95-100% of that
market is already outsourced; he sees growth rates of 8-15%, coming from
strong growth in the markets they serve.

Clearly, the opportunities lie in the services sector. But growth rates don't tell
the whole story. There is such a thing as growing too fast. Dunne goes much
deeper than the numbers to evaluate whether a company is likely to be successful
or not. He advises investors to watch a calculation he calls "return on value-added"
which is defined as the value EMPS companies provide by "cost-effectively
helping to design, produce, test and deliver high quality products in a very
responsive and flexible manner." He calculates this number by dividing
operating margins by the value added, defined as sales less the percent of pass
through material content. "Based on a review of public and private companies,
we believe the return on value added for well run turnkey EMPS providers is
30-35% regardless of whether the company participates in the high-mix/low-volume,
low-mix/high-volume PC or full system assembly portions of the electronics industry,"
he explained. "We believe it is also interesting to note that although consignment sales
have terrific gross margins, the return on value added is less than is achieved by a
full turnkey EMS provider, mostly reflecting the added inventory management
services of a turnkey EMS provider."

There has been considerable volatility in this services sector of the EMPS
industry. Mergers and acquisitions have occurred at an unprecedented rate.
The number of acquisitions has increased fourfold, from an estimated 25 in
1995 to approximately 95 in 1999. Dunne expects the number to continue to
grow, citing the telecommunications industry, that has only recently embraced the
model, yet has an outsourcing potential approaching $50 billion over the
next five years.

These acquisition activities have been fueled by three major objectives, as
explained by Dunne:

• Divestiture of OEM manufacturing assets. As these customers evaluate
their core competencies and seek to improve financial performance, they
shed costly manufacturing facilities to contract manufacturers. This has
happened primarily in the PC market in the past, but recently the wireless
and telecom industry has embraced the model.

• Achieve scale and geographical reach. Acquiring another company or
facility is the fastest way to take advantage of economies of scale and
accommodate growth. EMPS companies have very slim margins; yet
they are expected to have a global presence and handle large contracts
seamlessly.

• Acquire new capabilities. These might include niche markets, increased
technical and design expertise; enhanced supply-chain management skills,
manufacturing flexibility or one-stop shopping capability.

And guess what? Acquiring companies is not an end in itself. Strong
management, and a successful acquisition strategy, including the ability
to quickly identify and integrate acquisitions, are also key requirements.
In addition, industry leaders are separated from the pack by their breadth
of products and services, as well as customer, end market and
geographical diversification.

Supply-Chain Trends  Support Growth

Another capability Dunne believes is crucial to success in this industry is
the ability to effectively manage the supply chain. EMPS companies are right
in the middle of many OEM supply chains at a time when time-to-market is
becoming a critical factor in the ability to maximize revenues over a product's
life cycle. "We fully concur with studies that indicate the cost of being late to
market for a new product can be as high as 35% of the total profit potential."
Two-thirds of profit potential is said to be realized in the first half of a product's life.

Consequently, the ability to collaborate and partner with other players is a
key differentiator. Companies that manage their supply chains effectively will
speed time-to-market and maximize revenues. But there are barriers to supply
chain integration:

• Development of standards in communications and operating procedures
within and across companies

• Technological developments that can be disruptive.

• Role of the Internet: Spot versus budgeted market;
pricing and service metrics, rule making; value proposition.

• Can one model be flexible enough to accommodate
changing economic environments and different industries/ products?

As companies continue to analyze their core competencies and determine what function each of the key players in the supply chain ideally should perform, there will be winners and losers. This area represents opportunity and challenge, as companies that figure it all out, and find the right formula are able to capture a greater share of those outsourced dollars. Analysts like J. Keith Dunne will no doubt continue to scrutinize this industry with interest.

For further information, J.Keith Dunne can be contacted at Robertson Stephens, 415-781-9700.

For a full reprint of this article please e-mail: marilyn@wiringharnessnews.com