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Contractors snub factory purchases

Give us your work, but not your factory. That's what large contract manufacturers are saying more and more to technology companies these days.

4 min read
Give us your work, but not your factory. That's what large contract manufacturers are saying more and more to technology companies these days.

Winning manufacturing and design business from a hardware company often means buying that company's related factories. But recently some of the largest subcontractors, "electronic manufacturing services" companies such as Flextronics International, Sanmina-SCI and Solectron--are saying they don't need the extra capacity anymore. They say they have enough plants--they just need business to fill them.

"I'd like to believe they're being a little more circumspect in what they're buying, being a little more critical of the purchases," said Tony Boase, analyst with A.G. Edwards. "I think that's happening to some degree."

Factories could end up closing entirely because their work has been shifted to subcontractors, who already have their own, cheaper factories.

"Clearly, someone's going to have to shut down those plants," IDC analyst Kevin Kane said. "You have that (situation) across many regions."

Companies' rationale behind sending the tech assembly and design work to "outsourcing" contractors is that it's often cheaper than doing it themselves. It has been even more attractive lately because of the recession, which has made cost cuts more important than ever before.

Until recently, top tier contract manufacturers had to snap up OEM plants to land huge contracts. Flextronics swallowed Ericsson's entire handset operation early last year. Solectron paid Nortel Networks $900 million for several plants in 2000 as part of a massive outsourcing contract. Just last month, Sanmina-SCI landed a pair of deals that required them to buy factories from IBM and Alcatel; also, Hewlett-Packard said it's currently negotiating with Sanmina-SCI on an OEM divestiture.

Unfortunately for companies looking to unload factories, the biggest contractors say they have more than enough space. In fact, technology manufacturing as a whole has more factories than it needs these days, some industry analysts say.

Eventually, technology manufacturers will not have all of these facilities, Jure Sola, CEO of Sanmina-SCI, said recently. "Because we won't need them, and the customer won't want them."

More work has become concentrated among the top companies in contract manufacturing, and they have built space to handle it. But with the recession, many of these factories built or acquired during the tech boom aren't being used fully; some analysts believe the contract industry is running at 50 percent capacity.

Even in Japan, a place where electronics companies are considered prime candidates for outsourcing, large contract manufacturers are being careful about taking on new plants.

"We will go after that type of business, but go after it with our eyes open," Flextronics Chief Financial Officer Robert Dykes told an investment conference audience last month. "We don't want to be stuck with a plant that we'll have to close down in two years."

Contractors are particularly reluctant to take on existing factories in high labor cost regions such as Japan and western Europe, Kane said. "You're clearly not going to do any manufacturing in Japan when China is around the corner," he said.

Rather than buy plants in Japan, contract manufacturers are urging their customers to move the business offshore. Japanese costs are "out of line" with areas such as Hungary, China and Malaysia, said Dykes.

Fad or for real?
One consultant to the electronics manufacturing industry believes any reluctance to buy OEM factories is a largely temporary phenomenon spawned by the recession. Historically, about one-third of the revenue growth for major contract electronics manufacturers has come with the purchase of OEM assets, said Pamela J. Gordon, president of Technology Forecasters. In the long run, contract manufacturers need to keep buying factories to handle the increased volume of business, Gordon said.

Less than a fifth of the tech industry's goods sold are handled by contractor manufacturers, Technology Forecasters estimates. Ultimately, that figure could rise to as much as 80 percent within a decade, Gordon said.

"In a healthy year, you need the capacity," she said. "Electronics manufacturing services vendors still have nowhere near the capacity that they will need in the future."

The current economic climate won't stop contractors from buying OEM plants in certain industries, such as medical equipment and industrial instruments, Gordon said. "If there's a long-term contract involved with a niche desirable to the contract manufacturer, they're taking it," she said.

Size, to some extent, determines which markets are "desirable," Gordon said. Huge contractor manufacturers can make money on high volume business such as video game consoles and wireless phones. Small and midsize companies aim for medium volume, higher-margin products like chip manufacturing equipment, Gordon said.

But the slowing pace for purchases of OEM plants could be a permanent thing for the largest contract manufacturers, A.G. Edwards' Boase says. With Wall Street pressuring electronics manufacturers to improve their return on invested capital, those companies have to squeeze everything possible out of their current factories before new purchases are made, he said.

"We'll see them sporadically," Boase said. "But from an operating point of view, how can you really justify it? They've already got critical mass over here and over here and over there...This is the way it's going to be from now on."