Palo Alto Products helped create such popular products as 3Com's PalmPilot and some of the small "designer" PCs that emerged this year.
Flextronics manufactures PCs, servers and consumer devices for name-brand manufacturers. Financial terms of the deal were not disclosed.
Under the deal, Flextronics will acquire the company's design team, based in Palo Alto, and three assembly facilities.
"A contract manufacturer that can offer more services can get more business," said Malcolm Smith, vice president of design and engineering at Palo Alto Products. "This starts to turn the tide a little bit on what it takes to (make) a product."
If such mergers prove successful--and the contract manufacturing business continues to grow as it has--the PC market will increasingly be divided into two camps: unknown companies such as Flextronics that actually make products and well-known companies such as Dell and HP that will mostly serve as marketing and sales arms.
"We're moving toward the non-hardware hardware companies," said Roger Kay, an analyst at International Data Corp. "This is important for the PC industry because they can get out of the smokestack part of the business."
Such deals could even begin to fuel the growing trend of PCs originating from non-PC companies because nearly every manufacturing function could be obtained as a package of services, added Kay. "You could have the Fidelity Investments PC," he said. Indeed, late last year Mattel began selling Barbie- and Hot Wheels-branded PCs.
Contract manufacturing amounted to a $90 billion industry in 1998 and is expected to nearly double to $178 billion in 2001. Growth is pegged on more name-brand manufacturers seeking to take advantage of the manufacturing capabilities and Third World labor rates of some of these companies.
While contracting has been growing, the industry has seen a number of mergers and acquisitions. These deals have largely involved one manufacturer acquiring another.
Although contract manufacturers and design firms generally perform different functions, more mergers are likely because their tasks are converging, Smith said. Contract manufacturers already do limited design work, such as developing docking stations, he added.
Likewise, some design firms manufacture products when volumes are relatively contained. Palo Alto Products, which has approximately 1,000 employees, has assembly facilities in Asia and Texas and manufactured the first generation of Palm devices.
"I wouldn't be surprised" by additional mergers, said Smith. "Once the idea is on the table, everyone says 'of course.' The market is growing so fast we needed to add a broad scope of manufacturing services."
Flextronics competes against Solectron and SCI Systems. Palo Alto Products, meanwhile, competes against Ideo and Frog Designs.
The combination may also prove potent as aesthetics grow in importance in the PC business, said Kay.
"As the industry moves from what's under the hood to style, these guys become more important. It's a 'We-can-do-it-all-for you' kind of thing," he said.