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Tech Industry

Who really makes PCs?

Even though you bought a computer with a big-name brand, it's increasingly likely that the company whose name graces the box didn't build it.

Even though you bought a computer with a big-name brand, it's increasingly likely that the box wasn't built by the company whose name graces it.

Contract manufacturers are rapidly taking over the manufacturing end of things for PC makers, consumer device designers, and communication equipment providers. A $90 billion industry in 1998, contract manufacturing is expected to nearly double to $178 billion in 2001 as more and more name-brand manufacturers seek to take advantage of the manufacturing capabilities and Third World labor pool of the contract builders.

Most of that business, moreover, is going to a few top-tier manufacturers. Fifty different acquisitions have occurred over the past six years, paving a path toward multibillion-dollar mega-contractors. Some current brand-name manufacturers, such as Acer, even seem to be turning toward contract assembly as a way out of the bruising front-line PC wars.

"The vendors are finding it harder and harder to keep their costs down, and [contract manufacturing] is a way of dealing with costs," said Roger Kay, an analyst with International Data Corporation. "They have as efficient a manufacturing capability as anybody in the world, and they have begun to assume a larger and larger role for actual box-building."

While you may not have heard of companies like Solectron or Celestica, computer vendors such as IBM, Compaq, Apple, Silicon Graphics, Sun Microsystems, and Hewlett-Packard have entrusted much of their business in these companies' hands. Contractors handle virtually all of HP's PC manufacturing.

The work is becoming increasingly diversified. Celestica offers services in design, prototyping, assembly, testing, failure analysis, packaging, distribution, and repairs, said Tom Tropea, senior vice president of marketing. "We expect this trend to continue and accelerate going forward in the future," he told financial analysts last week.

Outpacing industry growth
Contract electronics manufacturers' net income has been increasing at 25 percent a year, but in 1999 and 2000 will likely grow by 30 percent, according to Paul Fox, an analyst at NationsBanc Montgomery Securities. PC vendors, according to other sources, are meanwhile seeing revenue grow in the mid to low teens with uneven income growth.

What's behind the success of the contract manufacturers? They can cut labor and inventory costs, get products on the shelves faster, and help companies penetrate international markets.

Going with a contract manufacturer speeds a product to market, Fox said, since manufacturers are very good at changing equipment to build a new product. Inventory costs also go down because of systems implemented by successful contractors.

But chiefly, contract manufacturing allows companies to put their attention where they can get the most bang for their buck: making their products different from competitors' products. A company thinking about contract manufacturing asks itself whether it wants to improve a product's software and features or whether it wants to "divert some of those efforts to concentrate on circuit board assembly."

The system chiefly works in a market such as personal computers where machines are assembled out of very standard parts, said Kimball Brown, an analyst with Dataquest. Contract manufacturing lets a company "put investment dollars where they help," such as marketing or managing the logistics of getting computers to the customers, he said.

Contract electronics labor costs
•  Brazil: $4.50/hour

•  China: $0.70/hour

•  Eastern Europe: $1.80/hour

•  Mexico: $1.80/hour

Source: NationsBanc Montgomery Securities

These companies also enjoy cheap labor rates. In Mexico and Eastern Europe, labor rates are as low as $1.80 an hour for contract electronics personnel, Fox said. In China, it's 70 cents an hour.

As in the PC field, consolidation is rapidly sweeping the industry. The six top contract electronics manufacturers--Solectron, Celestica, Flextronics International, SCI Systems, Jabil Circuit, and Sanmina--together have acquired 50 manufacturing sites across the world in the last six years.

But while there has been lots of consolidation, there's plenty of room for more, said Fox. The top 10 contract manufacturers together hold only about 25 to 30 percent of the market, he said.

Contract electronics manufacturing accounted for $90 billion of the $600 billion electronics market in 1998, but the contract manufacturing is growing faster than the industry at large, said Solectron chief executive Koichi Nishimura. By 2001, that share should increase to $178 billion of $768 billion, he said.

Solectron has a substantial piece of the action. From September through October 1998, the company had nearly $2 billion in sales, a huge step up over the $1.1 billion it had the same quarter in 1997. "Outsourcing is increasingly becoming the primary manufacturing strategy for original equipment manufacturers," Nishimura said.

Contract manufacturing can also be a good exit strategy for a company that has computer building expertise but can't keep up with the top PC vendors. Acer, for example, builds IBM's consumer-oriented Aptiva computers, sources said.

Number of new plants
Number of new facilities that top six contract manufacturers acquired in last six years.

•  Solectron, 13

•  Celestica, 12

•  Flextronics, 10

•  SCI Systems, 9

•  Sanmina, 5

•  Jabil Circuit, 1

Source: NationsBanc Montgomery Securities

Solectron: A case in point
Solectron, which recently displaced SCI Systems as the top contract manufacturer, was the leader in acquisitions with 13 new facilities in the last six years. Most recently, Solectron announced last week that it acquired IBM's Electronic Card Assembly and Test operation in Austin, Texas, offering employment to the 1,300 IBM personnel there and agreeing to build the motherboards at the heart of IBM's portable computers for the next three years.

But what's missing from the news release is the detail over just how much of the operation Solectron will take over. In the company's Securities and Exchange Commission filing, the company says it not only will build the motherboards, but also will design them, make prototypes, and handle returned products.

Or, as Nishimura phrased it during an analyst conference last week, the company will "manage the entire product life cycle."

Going forward, contract manufacturers will get new revenue from existing customers by "expanding beyond printed circuit board assembly into system integration, testing, and total design, Nishimura said.

Solectron, which was spawned from a former IBM manufacturing plant, has IBM, HP, and Sun as its biggest customers, Nishimura noted. The company has 25 sites, including 20 factories, across the world.

But contract manufacturers don't align with single companies, but instead strive to keep their customer base diverse to insulate themselves from economic troubles in one sector or another.

HP likes it
HP is one company that has embraced contract manufacturing in recent years, and grown confident enough to hang its label on products manufactured by other contractors.

The company started outsourcing manufacture of its PCs in 1992, and now has reached almost 100 percent.

"Pretty much all our desktops, both home lines and business lines, are outsourced," said HP spokesman Larry Sennett. "Every company has realized over time the efficiencies of a company that's very focused on manufacturing."

HP's predominant contract manufacturer is SCI Systems, he said, though the company also works with Celestica and Solectron.

Is HP losing control by handing manufacturing over to another company? No, says Sennett. "The issue here is: 'How have you integrated your culture?' HP is fanatical about quality and reliability," he said, and the company makes sure "the partner is committed to maintaining the same level of quality." If it's not, HP finds a new contract manufacturer.

But quality hasn't been an issue, he said. "We have not seen a degradation of that since we have gone to outsourcing," Sennett said.

HP chose to handle contract manufacturing of its inkjet printers in a different way. There, HP has kept control over a few factories which it uses to roll out new products, making sure they take care of any manufacturing problems before handing off the bulk of manufacturing to other companies, said HP spokesman Jeremy James.

About 30 percent of inkjets are made by HP itself, but the company plans to cut that down to 20 percent eventually, James said.

There's still plenty of room for HP's intellectual contribution to the design of the machine, he added, pointing to HP's "ultracool" ventilation system and its special keyboard button to connect a computer to the Internet.

Linking with distributors
Contract manufacturers are moving closer to the companies that distribute PCs to stores worldwide, too.

Solectron and Ingram Micro, the world's largest PC distributor, are teaming up in an effort to become one of the dominant forces in contract manufacturing, said Ingram CEO Jerre Stead last week.

Under their "frameworks" alliance, Solectron and Ingram will cooperate to ascertain facilities around the world. Solectron will handle manufacturing and assembly, while Ingram will handle product fulfillment and delivery.

A joint facility will open in Newark, California, in April, to be followed in June by a similar facility in Dublin, Ireland.

"In 1999, we will have the capacity for 5 million to 6 million units," Stead said.

The two companies will largely focus on serving large companies such as Compaq and HP, said Stead. Factory capacity will be first allocated to these customers. Resellers who have their own PC lines (known as "white boxes") and who are existing Ingram customers will have the next spot in line for factory capacity.

Ingram does not have plans for its own brand of PCs, Stead said. "We don't want to get into that game," he said.

Although resellers may initially gain from this arrangement, they will also likely become a victim. White boxes, or machines without national brands, he said, will steadily lose market share to the branded PCs, especially since contract manufacturing reduces the overhead costs for these companies.

In North America, White boxes constitute about 23 percent of the market while in Europe they account for over 50 percent of PC sales. The white box level in Asia is about 50 percent. "In China, white boxes count for around 90 percent," Stead added.

With contract manufacturers' increasing toehold in other parts of the manufacturing business, is it likely contract manufacturers will cut the HPs and IBMs of the world out of the loop and go straight to the customer? Fox thinks not.

But while the name Solectron probably won't be splashed across a box, Fox said, contract electronics companies "will be better and better recognized over time."

News.com's Michael Kanellos contributed to this report.