Electronics Supply & Manufacturing held its second annual Editorial Advisory Board dinner in June in San Jose, California, which included a two-hour on-the-record discussion. The event was hosted and moderated by Bruce Rayner, Editor-in-Chief, Electronics Supply & Manufacturing with 12 of the 19 board members attending including:
Elaine Bailey, CEO, Escend Technologies,
Steve Boysen, vice president, Avnet,
Shoshanah Cohen, director, PRTM,
Craig Conrad. vice president, TTI,
Mike Kirschner, president, Design Chain Associates,
Hau Lee, professor of operations, information and technology, Stanford University,
Derek Lidow, CEO, iSuppli,
Gregg Macalusa, vice president, UPS Consulting,
John McCallum, high tech industry manager, Microsoft,
Jim Rosenberg, president, Alliance Group, Arrow Electronics,
Matt Sheerin, Senior Partner, Thomas Weisel Partners,
Bob Yenkner, director, world-class manufacturing, Americas, Celestica
The discussion ranged broadly across some of the big issues facing the electronics industry. One theme that ran through many of the comments was innovation – where it comes from and how to capture it. What follows is an edited version of the transcript of the evening’s discussion.
No more “next big thing”
Derek Lidow iSuppli. The electronics industry is going through a metamorphosis. Growth rates have decelerated precipitously in particular in the semiconductor sector but in many of the component areas as well. And the industry isn’t necessarily accepting that as a fact. They are still hypothesizing the next big thing.
If you look at the structure of spending on a global basis and the fact that the electronics industry is the world’s largest manufacturing industry, you can’t have the next big thing happening in the timeframe we need it to happen to change the fortunes of the industry dramatically [in the next business cycle]. So it’s just not going to happen.
So once you accept that growth rates can’t accelerate from single digits to the 20-25 percent range where most of us developed our practical experience, you accept the implications for the existing structures of the industry, the business models that work and those that don’t. Then you start to see there are major implications. And many of the business models that did work just aren’t going to cut it going forward.
For example, you can’t be extravagant on capital expenditures or research expenditures. You have to manage budgets tightly or ultimately the adage “build it and they will come” won’t work.
John McCullum Microsoft. It seems to me that the customer has also changed. It’s gone from corporate or government buying to a consumer market. I think one of [iSuppli’s] analysts have shown a cross over that has taken place in aggregate that the consumer market is now larger than the other sectors. I would think that has a major effect on prices as well.
Derek Lidow When you divide it all up, enterprise and household spending are very close to one another. They recently crossed over and household spending is a little bit bigger than enterprise spending and will probably continue to outpace enterprise spending.
Enterprise spending on IT and high technology products has become a lot more conservative – they are requiring well-documented ROI for new infrastructure more than ever before. That has moderated the growth on the enterprise side.
On the consumer side, what does it take for consumers to spend more? Consumers spend about 3 percent of all their income on electronics hardware – that’s a very large number. And when you consider that most electronics hardware comes with service fees – mobile phone costs or MP3 downloads – that’s starting to add up to a significant number. So for any more spending to take place for hardware, you have to give [the consumer] a hell of a deal. That means prices are a huge factor in the buying equation.
Bruce Rayner, Electronics Supply & Manufacturing. So it’s the end of the era of the Next Big Thing and new business models are emerging. Best Buy is branding its own TVs from BenQ, bypassing the OEM entirely. EMS providers are morphing into ODMs. The distinction between ODMs, OEMs and EMS providers is starting to blur. Where is the industry headed?
Matt Sheerin, Thomas Weisel. ODM margins were up in the high single digits and over the last few years have come down. After the bubble [in the late 1990s] EMS companies had so much exposure to communications business that the bottom fell out of the business. They have been through huge restructuring and are coming off operating margins of [low single digits] and are starting to move up. At the end of the day, the best EMS companies will have operating margins of 5 percent and the best ODMs will be the same.
The other thing is there is really a blur when it comes to these business models. Flextronics is looking more like an ODM than anybody else. But every EMS company, from Celestica to Jabil, have design services. They have some claim to the intellectual property. The competition will always be there, and there will be new ODMs and maybe new competition from China. So maybe 5 percent is not the right number and maybe it will be lower – but it’s a very, very tough business.
Bruce Rayner Is the competition in the EMS and ODM sector coming primarily from Asia?
Matt Sheerin Yes, primarily out of Taiwan and China. But US companies are all lowering their cost structures so they can be competitive too.
Bruce Rayner Is Europe no longer competitive?
Matt Sheerin No. Well, there’s Eastern Europe and that’s the low-cost manufacturing base for Europe. In the US it’s Guadalajara. A few years ago everyone though [Mexican manufacturing] was dead and it was all going to Asia. Now as everyone looks at new projects and weighs the costs of logistics, labor, shipping and manufacturing, Guadalajara probably has the best cost structure for North America so business is actually coming back here.
So it’s changing and in five years there may be other answers and other ways to look at it.
But Western Europe; yes, it’s probably over for volume manufacturing. There will be niche manufacturing certainly.
Blurring of the lines
Elaine Bailey, Escend Technologies. Why wouldn’t the ODM just go ahead and become an OEM? They are establishing their own distribution. So with distribution they have both sides of the hourglass: they have the ability to design and manufacture and the ability to distribute to the end customer and the consumer. Why wouldn’t they get the extra margin by reselling their own products and establishing their own brands and over time replacing their OEMs?
I think they are on the road to becoming OEMs.
Matt Sheerin There are marketing companies and manufacturing companies. And you have the marketing costs that will make it very difficult for these ODMs operating on very slim margins to do business. Unless they change the way they do business, for instance, like Lenovo in the PC business.
Derek Lidow But getting back the issue of margins and the implications for component suppliers. Looking at passive components, for instance, the EMS and ODM community very effectively consolidated buying power that has resulted in about 4 percent lower gross margins for passives companies on a worldwide basis.
And right now, there’s a titanic struggle going on in the multi-market semiconductor component sector as to whether or not buying power will be consolidated up by the EMS and ODMs or whether the OEMs will retain that pricing power. That’s ongoing.
Steve Boysen, Avnet. In that struggle the tide has turned, only because many of the large OEMs have wanted to get back involved in their supply chain and the pricing decisions being made. OEMs are starting to reinsert themselves again.
Derek Lidow That’s true but you have to realize that the buying power for multi-market components is more for the mid-sized customers and not for the big ones that have done price masking and the like, therefore it’s still an up-for-grabs situation because the EMS providers can make an effective case to their mid-tier customers that their buying power may be worthy of the OEM turning the buying power over to [the EMS provider].
Gregg Macaluso, UPS Consulting. Regarding the comment earlier about Guadalajara and the move of manufacturing back to North America, we’ve been studying what we think is a wild disparity in that. As Lean and Six Sigma practices has enabled companies to assemble products in an hour or less it has the ripple effect right down the production supply chain. From an economic standpoint, we at UPS think that the disparity between manufacturing lead times and how long we spend in logistics is a signal that we have to move much more aggressively toward a model that mitigates that disparity -- between a product spending 35 minutes in the factory and three weeks on a boat.
From an economic standpoint and from an operations standpoint that disparity just can’t stand. We know that’s the case – so we need to bring a solution pro-actively otherwise we’ll get left behind.
To the point of moving centers of mass to where there is some equilibrium around logistics costs or the total cost of a supply chain making far more sense than 35 minutes in production and three weeks on a boat and the implications on forecasting – we think it will go much more toward North American-centric and [UPS] will move accordingly.
Steve Boysen I was at a customer earlier this week. Their manufacturing lead-time is less than a day and their lead-time in the time it takes logistically to move products around from manufacturing [is measured in weeks.]
Gregg Macaluso Logistics is clearly the long pole in the tent. Were almost nothing else matters other than the logistics time. As I’ve said before, the only people making money in this process are companies like UPS. In the long-run that disparity will not serve any of us.
Matt Sheerin The comment about lead-times makes absolute sense, but the bottom line is that for maybe a Dell the lead time is a day. But if you go to the EMS or the PCB manufacturer or the packaging company, someone is holding that inventory –someone is paying for it. So that’s the big issue. For Dell, they are just paying for it when they take ownership. But for the other players in the supply chain, what is the true lead time from the fab or the packaging company to the customer? That’s the question.
Gregg Macaluso We are constantly dismayed that the conversation around Lean and Six Sigma is always around waste, which quite frankly bores a lot of people. Our suspicion is that the most important factor around Lean is that the whole principle was based on flow – and there is nothing inherently in the laws of physics that makes logistics flow. It’s a batch process. As long as that’s a case – three weeks is a reality.
Derek Lidow Right now, the electronics industry is the largest industry on the planet: $1.2 trillion is electronics hardware being produced by OEMs. About $400 billion worth of electronics components goes into that output. So you are talking about $1 billion a day in components changing hands, and you are talking about $3.5 billion a day in hardware.
At some point in the future – probably determined by UPS – the electronics industry will warrant a hub system unto itself. Probably out of Anchorage, Alaska, with two-day lead times to anywhere around the world.
It is sound economics to do that today.
GreggMacaluso It is an accurate statement to say however that the movement is still in batches that does not represent or replicate individual companies today.
Derek Lidow A hub and spoke system with cross docking in Anchorage would accommodate the variations in the electronics industry and dramatically reduce the overall cost to the industry.
Bruce Rayner Gregg, are you talking about shifting production out of China to North America to reduce the logistics cost and therefore the total cost of ownership?
Gregg Macaluso Yes, that’s right. The mere fact that [logistics] lead times are somewhere between two days and three weeks is the real problem.
Craig Conrad If you look at the industry from the component or end product level – we tend to talk about the big guys – yet so much of the industry is the small guy. I would offer that their value proposition has nothing to do with cost and logistics but about speed, flexibility and technology – total cost is a consideration, but it doesn’t need to be manufacturing.
Gregg Macaluso They are more nimble in what regard?
Craig Conrad A customer asks an EMS provider to help him out over the weekend and make a diving catch. So much of the valley is small business I would offer that a lot of the growth comes from the fact that it’s the small guys that are driving the business, not just the big guys.
Derek Lidow What the numbers show is that the top 10 electronics OEMs [measured in revenue terms] consume about one-third of all components. The next 90 companies consume a little over one third. Then everyone else below the top 100 companies consume under one third. The top 200 companies consume over 90 percent of all the components.
The little companies don’t add up to much in the industry. They are important as a breeding ground for the Microsofts and Intels of tomorrow, but they don’t represent a lot of buying now.
Craig Conrad But when you look at companies like Cisco, how much of their success has come from buying smaller companies and consolidation rather than growing the business?
The future of innovation
Bruce Rayner Which segues into one of the topics on my list: the role of innovation. Is the source of innovation changing? We are seeing the demise of the R&D organizations at some of the world’s largest OEMs. There’s more collaboration going on between ODMs, EMS providers, independent design houses, semiconductor companies and OEMs. What’s the role of the small OEM in this process? Where will innovation come from for future electronics products?
Bob Yenkner, director, world-class manufacturing, Celestica. I think you have to look outside the traditional OEM. Our experience is that you get a lot of the non-traditional companies in aerospace and automotive industry starting to do more development work in electronics and they are coming to the EMS industry for help. Are they outsourcing it? Yes, we see more of it coming our way.
Bruce Rayner Celestica is involved in product development?
Bob Yenkner Yes, both in terms of collaboration with the customer and as an exclusive [outsourcing relationship]. We’ll tag team also. We want to be a partner in the development process.
Are customers trying to save money, are they looking for new ideas and innovation? Are they looking to us for a missing piece? Yes, all of the above. It’s an indicator that the whole industry is moving innovation from the exclusive domain of the OEM to the ODM-level – they are pushing it down. So at the top of the heap you have the people selling the product, but below that everything gets done: design, manufacturing, the whole nine yards, gets outsourced.
Shoshana Cohen, PRTM. One of the things we continue to see, which is quite surprising, is that the [design engineering] and development side of the business isn’t always aware of the developments on the supply-chain side of the business.
We’ve been talking about collaborating between companies – but one of the things companies are not that great at is collaborating within their companies.
Developers are out developing and supply chain people are off creating the optimal supply chain network, and they sort of forgot to tell each other what they are up to.
We still see a lot of the work being done to optimize the supply chain is about fixing problems that have been incorporated into the process or product because it wasn’t taken into account when the product was first developed.
Even something as simple as configure to order: if you had designed a product optimally upfront and you knew it was going to be configured to order, you knew where it was being configured, and you knew the time from when you got an order from a customer and how long you needed to configure to order and ship it out, you probably would have designed the product very differently.
So what you are seeing is all this catch-up to try to accommodate for the fact that it wasn’t designed properly in the first place. You now have to go in and put in an extra hub or extra expediting to improve the process.
Michael Kirschner, Design Chain Associates. We are still seeing a lot of the old throw-it-over-the-wall approach to design.
Shoshanah Cohen Yes, but it’s still inside the company. We talk about partnerships and collaboration but they kind of forgot to do it right within their own companies.
Bruce Rayner It’s the perennial problem of poor communication.
Michael Kirschner Outsourcing your manufacturing and ownership of the supply chain puts that even further away from the development side of the business. And as those developers become less and less familiar with manufacturing and even procurement, because they can no longer just walk down the hall and talk to the manufacturing engineer or a procurement person. You just see terrible, terrible designs.
In the semiconductor industry, everyone is going through a foundry. Well, there is some level of competitive advantage that a design engineer can create when he’s designing a chip to a manufacturing process that he understands.
With ownership of the manufacturing process now being outsourced to a foundry where he has no control over it and the process parameters are dictated to him, doesn’t he lose some advantage? Does he lose some capability of producing an optimal product?
It’s not just at the OEM level, but we see it down through the chain, to the component manufacturers too. And with all that consolidating at five large foundries, who has the control, the power?
Bruce Rayner Does this outsourcing trend inhibit or limit product and process innovation?
Michael Kirschner That’s my concern – of course, all the big R&D labs have atrophied in the US anyway.
Three stages of innovation
Hau Lee, Stanford University. When you talk about innovation, the innovation does not have to be confined to the product level of innovation. I think what the electronics and high-tech industries are lacking often times is innovation in the business model: ways to create the business model.
So if I look at the electronics industry, I think there are three stages of evolution of companies trying to create value and improve their market position and the competitive position of their companies.
The first is to focus on process improvement. Process improvement is about trying to be Lean, squeezing every ounce of fat or waste or cycle time out, improving the process by getting a better tool or better planning system to boost efficiency. There were a lot of companies last year that presented at the Supply Network Conference that have achieved tremendous value and created good mileage through process improvement.
The second stage is the restructuring of the process. Companies outsource or move to China or Mexico or Eastern Europe, or some combination of the above. They are not just trying to improve the process, but fundamentally change and restructure the process. They are trying to reconfigure or change product design to reconfigure their product or process in order to have the mix of benefits.
We look at the last three years of the Supply Network Conference, there are big issues that people were talking about – how you need to outsource, or move to China. Of course there are caveats as well, but there are a lot of good lessons that people have identified and shared.
The third point which I think is emerging but not as yet so common that people can talk about is the innovation in the business model. What is this? It’s about what are you selling, how you are changing the kind of product or service you are providing, or even changing the customer. The way you view your customers is different.
So I’m looking at the Xbox 360 that Microsoft is developing. It is an example of a new model. Microsoft is trying to place the game box as the center of the home: the central nervous system of the home. So that is an example of a new business model.
TSMC has done the same thing– they started with total process improvement trying to get cycle time down, how to get efficiency up and they started to make some supply network changes by moving some fabs to China to leverage the lower cost.
But the biggest payoff that TSMC discovered cam when they became more than just a fab, when they started providing design services and giving design rules. That’s what I call business model innovation, not just pure product or process innovation.
I just came back from Mexico and one of the world’s most successful cement companies is Cemex. It’s successful because of its focus on process improvement – very efficient manufacturing [and delivery] of cement. This is a low tech company – I call it non-glamorous – that uses RFID to track cement.
But the interesting business model that they are creating is that there are a lot of Mexicans in the US that are working hard and making money and they want to send money back home. A lot of the money they send it used to build houses. So Cemex thought why don’t we set up an agency so these Mexicans outside the country can go through us and buy our cement because they need to build houses for their families. So Cemex now helps them channel money and they buy the cement directly and Cemex ships directly to their Aunt or Uncle. This is a business process change.
Toyota also is an excellent company in terms of process improvement. They invented kanban and just in time inventory management – all these Toyota production systems.
Of course, they also have process restructuring, but when they introduced the Prius, they needed to change the business mode.
The traditional model was they sell cars to dealers and Toyota collected that money right away. This worked well. Toyota cars are good sellers so they never had a problem. But the way they developed this model was I make a car, I send it to [the dealer], [the dealer] sells it to the customer. It’s [the dealer’s] problem if they don’t sell it.
But when they introduced the Prius, it was such a risky product that they didn’t know what the market reception was going to be. The investment required by the dealers was huge – they had to buy a whole new set of spare parts, new battery chargers, all very expensive equipment. So the risks were totally imbalanced. Not like the conventional model.
So Toyota changed its business model because the risks were so unfair to the dealer. They recognized that the dealer would not be motivated to sell the car based on the imbalance of risk and reward. So Toyota ultimately decided that for this car, it would own the inventory centrally and when the dealer sold a car, Toyota would ship it to the dealer.
The result was that the Prius has been a phenomenal success. Of course, the car itself has to be sound but the business model change was also a significant factor.
So I think in the high-tech industry we should also pay attention to changes in business models in addition to process improvements and process reconfiguration. It’s a way to create big value.
Jim Rosenberg, Arrow Electronics. I agree, but I also think that the whole technology adoption in the last three or four years for the supply chain has really helped both in terms of information and flexibility. It’s certainly organizational changes and process changes, but it’s also technology adoption that wasn’t there 10 years ago. I’m sure that in the last three or four years, the technology investment has really been a contributing factor and a driver in that process.
Hau Lee I agree with you. At least the climate is ripe for people to make those changes.
Steve Boysen In describing the things you are talking about, Professor Lee, you are focusing on not the process but the system. That’s what I think you are talking about when you talk about Toyota, it’s about looking at the whole system. How do you get it from design to manufacturing all the way to the customer? What’s the most efficient way to do that so the whole system benefits, not just the particular part of the process?
That’s one thing we wrestle with in the supply chain. We talk about components, but when we stop and look back at what is the total system to get it from components into to the end user’s hand, what should that system be?
I don’t know that we’ve got the answer – we have got bits and pieces, , but we [don’t have] the total connection that goes from the customer all the way down, a la the Toyota model, that takes it from womb to tomb.
Plea for harmony and trust
Craig Conrad To that point, I’d like to throw out a controversial subject: If I take a look at our supply chain, whether or not it’s a lack of trust or a lack of profit or a variety of other reasons, most of us want to hold back information from the guy we are passing it to because we don’t want him to take some of our profit.
If that’s a component supplier, there’s apprehension to pass it to the EMS, or the distributor, etc., etc. It’s hard for me to imagine going to this harmonious environment that Professor Lee is describing at Toyota when there is not a collaborative relationship between the players and they are concealing information at every point of contact.
I think that is a big challenge, that there is not harmony in the supply chain and there is an incentive to not pass on that information. So I’d like to toss that out because I don’t think we will ever really be efficient until there is seamless information flowing back and forth. And I don’t see, in fact arguably I’d say that we are further away than closer today in sharing the information. Not just forecast information, but true cost of product.
Hau Lee In the case of Toyota, I think clearly there is a trust issue –a very important trust issue that I think the electronics industry is not the same as other industries. So there is still a lot of potential conflicts and mistrust. But as Craig says, you cannot create a truly new business process model if everyone is holding back information.
What is fascinating is that Toyota is not using the same model for the second-generation of Prius. So for the first generation of Prius, they said, “look, we’ll change the business model to help launch this new product.” And Toyota suffered a bit [on margins], but now the Prius is established and people are lining up to buy them. So for the second generation, Toyota converted back to the old model.
So there is a temporal side to the issue here – sometimes when you have to trust, it’s hard, that this time around you may have to change the risk profile, but when the risks change you go back to the old model that is more equitable. But that is hard to achieve.
Gregg Macaluso When you wrestle with that issue, and I’m sure you do. There must be a better business term than lack of trust. There must be an economic term, like incentive, some sort of change in the business model that you think can turn that tide. What is that term that comes to mind that is not so esoteric as what we have all been talking about for years about collaboration, trust. There must be a better economic case to be made that you think would turn the tide.
Craig Conrad It’s a very complicated issue. The thing I would say is that if you go back to the old vertical business model, where everything was contained inside the four walls, there was an open communication throughout and the incentive to cooperate was there. There are cost efficiencies and speed efficiencies and flexibility to do that. They were all working toward a common objective and they were all working as a team.
I don’t believe in our industry there is a lot of examples of that teamwork anymore where there is transparency of communication and information going back and forth for the common objective.
The new [outsourced model] should work having one company focus on design, another on supply chain, and another on component marketing, but I don’t see a lot of examples of tremendous success because everyone is holding back.
I’m not saying we should go back to a vertical model, but we won’t fulfill the real potential of the supply chain until we improve our sharing of information. I think we are a long way away and arguably, I would say we are further away today than we were 10 years ago.
Shoshanah Cohen All of this seamless transparency and information flow is possible today. If I was selling software to help you do that, I would have a great pitch about what I can do for you – how you can optimize your supply chain and everybody wins. You can optimize it at every node and in total costs are lower, and we can now share all this money we have saved. Doesn’t that sound great? Then you throw in real people and real companies and multiple P&Ls and the whole thing just falls apart.
Jim Rosenberg I think it gets back to the common denominator about structure and organization. We have certain models with different suppliers with different expectations, and we have some models where the information is flowing perfectly, everything is totally above board and open where everyone wins – we win, the supplier wins, the customer wins.
Then we have other models, to your point Craig, that are more traditional distribution models that don’t quite work that way. I think it’s more about organization than technology or supply chain issues.
John McCallum I agree with you. I think the technology is there, I think it’s the trust issue. People have to believe that the information they share is going to be used appropriately. It’s proprietary information and will not be used to get a better margin out of these people because now I have better information about them.
Shoshanah Cohen But even if it’s not going to be used against them, someone wants to come out the winner. They might all be buying the same component from the same supplier but someone wants to come out the winner and get the lowest cost. And so, if everyone gets the same price then everyone will be happy. No one is going to agree with that – someone has to win.
Steve Boysen One thing that I think has taken us a step back from our perspective is the reverse auctions: that’s destroying trust faster than anything else. We have highly complex relationships and we are delivering complex solutions and the next thing you know someone says, “If you want to keep our business you have to do business this way, otherwise you are out.”
Derek Lidow The structure of the electronics industry is such that if you model everyone’s specific interests in the supply chain, you cannot create trust; it’s impossible.
But our research shows that you don’t need trust. If you have good third-party information and if it’s at the right granular level, that is actually a better source for aligning the supply chain than trying to get the hoses hooked up correctly [between supply chain partners] and then learning to trust what’s flowing through the hoses.
The XBox phenomenon
Craig Conrad Is there a correlation between the margin degradation in our industry and a growing lack of trust?
I talk to OEMs that use EMS providers and their cost [to outsource manufacturing] is 20 percent what it used to be [to manufacture the product in house]. Yet if the EMS provider is a penny high on a part, they will continue to beat up their EMS provider. So what’s the EMS guys’ incentive to share the information with the OEM? Even though they are saving the OEM huge amounts of money, sharing information just leads to lower margins.
Hau Lee Your question is a good one and I’d use it to generate another question. It’s true that the majority of companies in the electronics industry don’t have trust or are not sharing information and are trying to squeeze each other’s margins. That is a general observation.
Yet, there are also cases of companies that are working together. Maybe they don’t share everything because perhaps they have transparency of total information as Derek suggests. But they share appropriate information, that’s sufficient.
Look at the XBox from Microsoft. That they were able to work with Nvidia and Flextronics for generation one and create a product in 14 months versus the PlayStation in 20 months [is the result of successful collaboration]. So there are some success stories here but it is not the majority, it’s a small number.
I think the question should be: What are the lessons from these cases that we can roll up and have more widespread business model innovation. What is it going to require? Is it everyone has to open the kimono?
Derek says no. So we need to look at more examples of how they did it. We can educate and promote these characteristics across the industry. That’s the future of this industry.
Steve Boysen John, when Microsoft did the XBox, didn’t they do this in a vertical fashion? Didn’t they start moving people in a secure area to develop the product?
John McCallum So it’s actually gone in the opposite direction with the second generation of Xbox – the XBox II. I wasn’t around for the first generation so I don’t want to speak to that.
The next step for XBox II is that it’s becoming a fables semiconductor company, where we are actually doing the designs on some of the chips and outsourcing the manufacturing. So the model is actually changing and iterating again, so we are designing multiple versions of the XBox concurrently.
The value of distribution
Bruce Rayner I want to pick up on something that Derek said earlier. You said that distribution and EMS and ODMs are the only sectors to see gross margin decline in aggregate. So let’s talk about distribution. What’s behind the decline in margins for distributors and what does the future hold?
Jim Rosenberg We’ve talked about trust and sharing information, but if you remember some of the earliest outsourcing wasn’t about an OEM going to an EMS provider and saying, “What is the price for you to supply this board?” It was, “Give me the cost of every component on the board, the price of manufacturing, give me everything.”
For whatever reason, the EMS guys did this. It became an entire information flow and it’s hard to make money when everyone knows exactly what you have to spend.
One of the things that hurts distribution is our suppliers know exactly what the price we have and exactly what the resale is because we give them point-of-sale information.
So think about the real world for a minute: how often do you go in and buy a product where you know every bit of information about the exact cost of the product? Maybe some of the issues of the automotive industry is that all of the technology, everyone knows the invoice price, but ultimately it gets back to the issue of trust.
You think about jewelry, about other things – it’s about value to the customer. What their perceived value is.
The issue with the EMS business and with distribution is everyone knows the exact cost, the exact price of every little piece of it. We have suppliers coming to us asking, “What is the cost of logistics for you to move this product from A to B?” Everyone wants to know exactly the cost along the way.
That’s different than Microsoft and Intel. I don’t think Microsoft tells their customers exactly how much it cost them to make a product. It’s about value – what’s the value to the customer of buying the product. It’s about value, not cost-plus. I’m oversimplifying it, but it’s one of the reasons that margins are different in distribution and EMS than in some other businesses.
Bruce RaynerIt also implies that the customer is not placing value on the service you provide.
Jim Rosenberg That’s true, and we have lots of customers where we get a lot higher pricing even at higher volume because there is a value we are providing. The supplier can look at that and say you are making too much money so I’m going to change your cost. So it’s not all about value, it’s about value to the supplier and the customer, just like the EMS guys who are in the middle between their suppliers and customers.
Derek Lidow Electronics manufacturing at this point in time is a pure commodity service. Virtually any product – you can get the latest digital TV from virtually any ODM and you can be in the leading edge TV business with an investment of less than $1 million.
We just did a study of handsets: there are over 100 handset brands in the world right now. So when you have 100 brands it “commoditizes” the whole structure.
You can argue whether the industry did it to itself or if that’s the stage of maturity that the industry is in, but at this point in time, those are the facts.
Jim Rosenberg I don’t disagree, but if you are a large EMS provider and you have the buying power to get a lower price on certain commodities, you should be able to potentially influence your margin based on buying power. and if all it is what you pay for the parts, versus the labor, I think there still is a little bit of margin degradation.
Derek Lidow It comes down to the business model. What is the core competence of what you are selling. And there are conflicts of interest in the way the outsourcing was structured originally – fundamental problems that created issue that have come back to more narrowly define contract manufacturing in older classic sense, rather than in the supply chain management sense. But even in the supply chain management sense, there are so many brands out there that that widely disseminates information. Information is a lot less valuable.
Bruce Rayner In the context of Professor Lee’s comments about innovation of the business model, is there an innovation in that distributor’s business model that needs to happen in to create in the suppliers and customers minds a higher sense of value? Are you trying to find that formula to boost margins?
Jim Rosenberg Yes, obviously we are always looking at were we are creating value for the suppliers and the customers. At Arrow, we are creating opportunities for our suppliers to do demand creation at 50,000 customers around the world that they certainly can’t do on their own.
There is a fair amount of value in our proposition to help them get their products to market, get their products designed in. There’s the logistics side, suppliers can’t get 10 or 50 pieces shipped to customers around the world but we can. And there is plenty of work we do integrating forecasts between our OEMs and EMS customers to help them move product around the world. So yes, there are lots of areas for a distributor to provide new services as it relates to supporting customers, the supply chain, design-ins, and logistics support and capability.
So I’m sure I speak for the other two distributors when I say that is our value proposition, bringing technology to customers and expanding the supply base for our suppliers into our customers.
I think that was the point of the comment about reverse auctions: if it’s all about price then it’s not a very interesting business for us. At the end of the day, there is no value in that. So we are looking at where we provide value to both the customer and the supplier.
raig Conrad Certainly in the last 10 years there has been considerable consolidation in the industry. If you were to go back in time and ask, “Who is the customer of the distributor.” Not who pays the bills, but who provides the margin? I think we have two customers then: the supplier and the end customer both give us the margin.
Going back prior to this period of rapid consolidation, there was some exclusivity and uniqueness to our line cards that gave more value to the suppliers. And they were willing to give us more margin because we gave them exclusivity.
I think now, in a consolidated industry, suppliers are less willing to give us exclusivity. It gets back to the trust factor, not in terms of integrity but as a business model. And I never think the customer was willing to pay a much higher price to the distributor. They thought their method of payment was based on economies of scale: they’d give us more volume and market share but the real margins were coming from the value creation from the supplier. I think because of line card proliferation, it’s not as compelling as it used to be.
Innovation in chips
Bruce Rayner Turning our attention to the semiconductor sector, and in the context of comments made so far about business model innovation and lack of trust. What are the trends shaping the future?
Michael Kirschner Consolidation of power is what I see.
Derek Lidow What the data shows is that the semiconductor industry is not consolidating. The number of semiconductor companies is still expanding. At this point in time very rapidly in China when it is quite easy and straightforward for a Chinese semiconductor company to be funded. [In June], Intel announced [a fund of] $200 million to invest in new semiconductor companies in China. Many venture capitalists have been concentrating [attention on China] for the past couple of years.
Michael Kirschner Are they just design houses or the old semiconductor model of building fabs too?
Derek Lidow It’s worth being cautious about talking about the old semiconductor model – ultimately you are seeing a bifurcation of core competencies. The semiconductor industry as a whole has been an intellectual property business, where the design side of the business has generated the margins as opposed to the manufacturing side of the business.
So the manufacturing side of business, which is highly asset intensive, makes sense to go into the hands of those that have [lower] cost of capital and are asset managers par excellence, because it wasn’t the source of the margin generation.
So the semiconductor industry is going to survive based on its ability to generate intellectual property in the form of nifty designs of circuits and ways of solving specific electronics problems. That hasn’t changed. But what the investment community is saying by virtue of the fact that they are pouring new money –brand new money – into start ups in the semiconductor industry mostly in China is that they believe better solutions or lower cost solutions lie ahead for existing sockets. So this means that the pressure on Western intellectual-property-rich companies is going to grow for the foreseeable future.
Craig Conrad, TTI. Do you think semiconductor companies will become more sophisticated pushers of trends rather than pushers of product? Do they need to be visionary about the next wave of applications?
Steve Boysen It depends on which side of the technology chain they are on. You have a couple of big guys – Altera and Xilinx – with high-end products. Then there are the other guys, who want to be in MP3 players so they have to go out and build flash memory.
Derek Lidow We did a study on the semiconductor industry and what business models worked in the last business cycle. What it showed – 15 percent of semiconductor companies outperformed the rest by a factor of 4X, This group stood out and everyone else was worse than average. Those companies used a different business model and so they stood out.
Jim Rosenberg I assume some of these companies were not selling commodity products and so had a different attitude about how they are selling their products. I’m guessing I know who they were. So I’d suggest these guys succeeded because of innovation.
Derek Lidow Some were right in the commodity markets. The most commodity of the commodity.
Bruce Rayner So it was business process and business model innovation?
Derek Lidow It’s a number of things, but they got it. And when you get it, when you are among the first to change the business model, you leave the rest behind.
And in the semiconductor industry, which is a highly competitive industry, 15 percent of the companies did that in the last business cycle.
Hau Lee This new business model you mentioned is fascinating. But some of these new business models involved the same product but it’s repackaging because that’s what customers value.
Derek Lidow They restructured their businesses to make it happen.
Hau Lee There’s a company called Big Cola based in Peru. What they discovered was that Pepsi and Coke controlled the market everywhere in the world, even in South America they are dominant. So this company came up with a new packaging – they made the bottles larger. Instead of 2 liter bottles, they offer 2.6 liter bottles. Instead of offering 10-20 different flavors and possible variation, they offer only one.
In South America I was told, family sizes are large so they buy the Big Cola. Also, since they are only producing one model, their production costs are low, so they are making good money. So they are cheaper than Coca Cola and they are larger, and they have 10 percent of the market. That’s not bad.
So this is a business model reengineering. It’s not reengineering the product itself but it’s the offering – what is the offering design that gives the advantage.
Bruce Rayner We’ve mentioned Toyota’s Prius and Microsoft’s XBox as examples of business process innovation. Are there other examples?
Shoshanah Cohen This is a really simply thing – it’s not innovative per se. But Nokia, when they came out with the snap on covers for phones, everyone was going nuts setting up factories so they would wait till the last minute when the order came in, and then they’d decide if it was going to be red, or blue or whatever. And someone said why don’t we put four covers in the box?
And everyone thought that was crazy, because it costs a lot more to produce four than one. But it worked for them. Yes, the standard margin is lower on that phone than others, but the consumer likes it because now they can buy one phone and get four covers.
im Rosenberg Or they give the service provider the covers and they ask the customer what they want. So it’s cheaper for the producer but it still provided the customer with choice and value.
Shoshanah Cohen Right, it has nothing to do with the product – it’s about the cover.
Craig Conrad I’d argue that in distribution, [an innovation] is the emergence of catalog companies that have seized the opportunity with the Internet. They have made it an extremely good customer contact tool and have adjusted their business models from a traditional catalog business that was going to be put out of business 5 years ago to today where they are fast growing and getting extraordinary profits and margins.
I think in distribution that’s a great example of adjusting and seizing the moment.
In everything I’m hearing, whether it’s in business model, or marketing or design, I think our industry perpetuates itself on innovation. That’s the common thread of everything we are talking about.
Jim Rosenberg Today, innovation is no longer just about product, but about [many things] including product and process. That’s the big change – when I was talking about technology adoption, it’s important to have innovation not just at the product but at the process.
Craig Conrad Yes, look at the Dell model. Real commodity product but real innovation in the process and business model.
Bob Yenkner But where is the innovation coming from? I don’t see anything out there that’s new – everything is a variations on a theme. Bigger screens on a TV, etc.
Gregg Macaluso That’s why it’s a flavored-mayonnaise economy It’s about fleeting differentiators. And one of the things I’ve heard all of us talk about is that fleeting innovation or differentiation is impossible to ramp up to because the innovation is so short lived. In the time we have to ramp or made it scalable, we become passť because the barriers to entry have been overcome.
My sense is in there somewhere is a clue to what is the variable that would allow us to have a little more sustained innovation and differentiation.
Is it process, it is product, is it business model that would allow for more than to write rebate checks to retailers in 180 days? We have to do better than that – if we can’t break the code, the colored cover cell phone phenomenon seems to be [where we will reside].
Craig Conrad I love to look at successful teams for guidance – sports teams or whatever. The common attributes are: common goals and good chemistry, an ability to work together. I look at the supply chain and you just don’t have a good team. And I guess the question I have is can we fulfill all of this potential if we don’t align to a better supply team than what we have now.
Michael Kirschner I know design teams that have been together for many years. They work very well together. But in the supply chain were there are 100s of suppliers, we are horribly fragmented. How do you create a team out of such a horrible mess?
Hau LeeThere are two types of success – it’s not enough to be a good team for 10 years but how do you create a team that can come together quickly?
Companies must be able to make advancements fast and maybe after a few projects, disassemble the team and a new team comes up.
I remember when I was younger and a very keen bridge player. In one form of bridge, you work with your partner for many years and become very skilled as a partnership. But there is another bridge: you go to the bridge club and assemble on the spot.
There are some people who are very good at this. They win games without a fixed partnership.
In our industry – which is very fast changing –we have to be able to quickly assemble a new team. The XBox team is an example of a quickly assembled team.
Bruce Rayner There’s one important issue we haven’t covered but is worth attention. That is the European Union’s environment compliance agenda, namely two directives: the restriction on the use of certain hazardous substance (RoHS), and the waste electrical and electronic equipment (WEEE) recycling directive. Where does the industry stand on preparation for these two directives?
Michael Kirschner Design Chain Associates did a study of people who have attended our seminars. In general, no one has finished the job of compliance. About 10 percent of those surveyed have not started yet, about 20-30 percent are just developing a plan and the rest are in the midst of execution.
What’s more frightening is WEEE. More than a quarter have not started to do anything about WEEE -- and you have to register in EU countries by August 13.
Also, you need to label the product’s box. One large contract manufacturer in the Valley said that only one of its OEM customers has labeled its boxes yet.
What more disturbing is that very few companies are designing for the environment or designing for recycling. I don’t know how OEMs are estimating the cost of non-compliance.
Craig Conrad And those are people that are more aware of the issues because they have at least attended a seminar. I think half of our customer are maybe vaguely aware or don’t have a clue of a plan.
Jim Rosenberg A lot of our customers haven’t begun but even with customers that have two or three years working the issues, they are frustrated because suppliers aren’t there yet. So even though customers are tracking and managing the issue, they are frustrated because they can’t get the information.
We have a lot of passives and electro-mechanical suppliers and even semiconductor suppliers that don’t have the information to pass along. So it doesn’t matter how good you are at manufacturing your products, if the supply chain isn’t there, you are only as good as your worst supplier.
Steve Boysen We did a white paper and found that 50% of our suppliers don’t know what they are going to do yet [with respect to RoHS].
Bruce Rayner There’s no chance that the EU will push out the date for compliance to sometime after July 1, 2006?
Mike Kirschner No, there is no rationale to do that.
Craig Conrad This is not about a date, it’s about a complete change in the way we do things. And probably for good reason – there are bad things out there that have to be dealt with. So I think that anyone that thinks this is going to go away, is naÔve. We all have to integrate environmental policy into our business plans because that’s the way we will have to live from now on.
You take a look at Europe, Asia, and this country – there isn’t anything you can find that isn’t moving toward more strict environmental laws. I think it’s easier to jump on the bandwagon than to be left behind.