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Automotive Market Driving Providers in Different Directions

(November 2009)

    Over the years, automotive electronics have held a certain allure for the EMS industry. The automotive sector has two qualities that EMS providers love to see. It has one of the lowest rates of penetration by the EMS industry, and the increasing electronics content of cars offers a built-in mechanism to help propel long-term growth in the segment. Despite the perennial promise of automotive electronics as an engine of EMS growth, not every provider in the space is an advocate of automotive EMS.

    Automotive electronics are often grouped with other lightly penetrated segments under the umbrella of nontraditional markets with lots of untapped outsourcing potential as opposed to the IT and communications sectors, which have been extensively mined by the EMS industry. But the structure of automotive sector sets it apart from other nontraditional segments. When car companies farm out electronic systems, the design and manufacturing work goes a company in the first tier of automotive suppliers. EMS providers in the automotive chain typically function as second-tier suppliers whose business in the sector depends on outsourcing from tier-one suppliers. Ultimately, this dependence on tier-one outsourcing has not been a recipe for success in the case of one EMS provider. Another has shunned the standard EMS role as a tier-two supplier in favor of a focus on providing ODM products for automotive OEMs. Yet other EMS providers remain committed to building automotive electronics for their tier-one customers.

Long-term growth still projected

    Although not all EMS providers have the same approach to the automotive electronics segment, they faced a common problem in the well-publicized slowdown of the automobile market that began with the financial crisis of 2008. A lack of car buying drove volumes down in the supply chain. But that wasn’t the only issue. Chris Thyen, VP of business development at Kimball Electronics Group, has seen cases where awarded programs or development work were delayed because of financial concerns. Program delays have also occurred for another reason. Thyen is aware of instances where the introduction of a next-generation module for a car platform has been postponed because the new unit offered only a marginal advantage over the existing technology. “We have seen where launches have been delayed for one and two years,” he said.

    But for Kimball Electronics, these effects have been confined to North America and Europe. “From what we’ve seen, the awards we have and the contracts for launch in Asia have carried on as planned even through the financial crisis,” Thyen noted. Kimball Electronics, the EMS subsidiary of Kimball International, has supplied tier-one customers for over 25 years.

    The unexpected drop in demand left excess capacity among the many tier-one suppliers who maintain internal manufacturing, but Kimball has only observed a single case of insourcing.

    More recently, the “cash for clunkers” program of the U.S. government has created unforeseen demand in the supply chain. While this effect may be short lived, long-term growth is still projected for both the automotive electronics TAM (total available market) and the EMS portion of the TAM. InForum, a market research service formerly known as TFI Quarterly Form, estimates that the 2008 TAM of $51.1 billion will grow at a five-year CAGR (compound annual growth rate) of 1.45%. But if you eliminate 2008, the four-year CAGR (2009-2013) becomes a respectable 7.2%.

    EMS revenue in the sector will grow faster than the TAM over both periods, according to InForum. Starting at $3.8 billion in 2008, EMS revenue will reach $5.4 billion in 2013, corresponding to a five-year CAGR of 7.6%, InForum predicts. Eliminating 2008 from the forecast results in a four-year CAGR of 13.7%. Based on InForum estimates, MMI calculates EMS penetration rates as 7.4% and 9.8% for 2008 and 2013 respectively.

    InForum expects ODM revenue in the automotive sector to increase at high growth rates, albeit from a low starting point of $500 million in 2008. The firm’s outlook calls for a five-year CAGR of 38.5% for ODM revenue and a four-year rate of 57.2%. Much of that growth will be available to ODMs focused on Chinese automobile production, says InForum. When the ODM numbers are added in, the five-year CAGR for outsourcing growth in the sector rises to 13.8%, representing the largest growth opportunity in InForum’s EMS/ODM forecast.

    “Severe damage to the automotive industry, combined with very positive behavioral and technology trends, make automotive a bottom-of-the-market opportunity,” InForum stated in a report released this month detailing its current EMS/ODM forecast. Despite chronic overcapacity, bankruptcy filings among tier-one suppliers, and pressures to innovate rapidly, InForum believes that “this is a tremendously exciting time for automotive electronics.” Not only are electronics the potential savior of the automotive industry and the key to automobile popularity, wrote InForum, but upheavals in the automotive industry create potential opportunities for contract manufacturers.

    Another forecast, put out by market research firm Electronic Trend Publications, estimates that the 2008 TAM for automotive electronics was $72.9 billion. ETP’s report, The Worldwide Electronics Manufacturing Services Market, Sixth Edition, predicts that the TAM will exhibit a five-year CAGR of 5.3%, despite a drop in 2009, and end up at $94.3 billion in 2013. In 2008, contract manufacturing (EMS) accounted for $5.4 billion, or 7.4%, of the automotive TAM, according to ETP. Interestingly, this is the same penetration rate calculated from InForum’s forecast. ETP expects that by the end of the forecast period in 2013, contract manufacturing sales will amount to $7.3 billion, equating to a CAGR of 6.2%. ETP projects nearly the same CAGR for ODM revenue, which will go from an estimated $970 million in 2008 to $1.3 billion in 2013.

Jabil pursues exit strategy

    Market researchers might be projecting long-term growth for automotive EMS, but Jabil Circuit no longer sees the automotive sector as deserving of its resources. During the company’s earnings conference call in September, Jabil announced that it expects to divest its automotive electronics manufacturing entity located in Western Europe during the company’s November quarter (Oct., p. 3). The company’s latest SEC Form 10-K identifies this entity as Jabil Circuit Automotive, SAS and states that Jabil entered into an agreement on Sept. 24 to sell the operations of this subsidiary to an unnamed third party. Furthermore, the 10-K lists Jabil’s facility in Meung-sur-Loire, France, as belonging to the entity being sold. Upon closing of the transaction, Jabil will no longer own this facility, which Jabil acquired in 2002 from Valeo, a tier-one automotive supplier.

    The divestiture in Europe is part of Jabil’s exit strategy for the automotive sector. Jabil president and CEO Tim Main explained during the September call that the company has been reducing its North American exposure to the sector over Jabil’s last several quarters. Main said the European operation represented 75% or 80% of the remainder of Jabil’s automotive business. By the company’s February 2010 quarter, “we’ll essentially be out of automotive electronics completely if this transaction closes,” he noted.

    Jabil will be ending its decades-long involvement with the automotive industry with whom the company was closely identified in its early years. In 1976, for example, Jabil made a name for itself by winning a large contract with General Motors. Over the years, diversification greatly reduced the automotive percentage of Jabil’s sales, but the company continued to promote its experience and capabilities in automotive electronics.

    Why is the company closing the door on its automotive legacy? “We have done several significant deals with major OEMs to try and provoke and activate an outsourcing process,” said Main. “I think we just counted cards and determined that we did not provoke a wave of outsourcing, and, along with the recessionary period and the restructuring and rationalization and everything else that’s going on in the automotive marketplace generally, that this is an end market that does not afford the company the type of growth opportunities or return opportunities that we really require to continue to invest in the area.” For Jabil, there are better end market opportunities to focus on.

    Although Jabil has not seen a swell of outsourced automotive electronics rolling its way, the company could have tried becoming a tier-one supplier. As a tier-one, Jabil would be in a position to control the supply chain for electronics outsourced by car brands. Though a potential avenue of success, this option “would require significant management attention, capital and risk that we’re not willing to take,” said Main.

Flextronics takes the ODM route

    Back in fiscal 2007, Flextronics decided that being a conventional tier-two supplier to the automotive industry would not be in its best interests. Building “SMT assemblies for Visteon or Delphi or something is not a model where there’s very going to be any real profit in it,” said Flextronics CEO Mike McNamara during the company’s analyst and investor meeting in November 2008. So instead, the company opted to focus on ODM products within the automotive space. The ODM model allows Flextronics to supply automotive OEMs directly, and the company is heavily focused on European OEMs. At the meeting, Flextronics reported that it would be supplying an overhead lighting model for all 2010 and 2011 Mercedes and lights for BMW models of the same years.

    Flextronics aims to grow its market share of electronics content within newly developed cars. Accordingly, the company expects to add “design and product competencies over time,” said McNamara during the company’s earnings call last month. Today, automotive business represents about 2% of Flextronics’ sales.

    The company has begun to make good on this pledge. MMI confirmed that Flextronics has agreed to acquire AFL Stribel Production GmbH, a supplier of vehicle electronics, from Alcoa. The electronics operations of AFL Stribel were formerly part of Alcoa Electrical and Electronic Solutions, which Alcoa announced was for sale in January. Alcoa EES was engaged in the design, development and production of electrical and electronic distribution systems for personal and commercial vehicles. In June, Platinum Equity, a private equity group, bought the wire harness and electrical distribution portion of Alcoa EES, by far the largest part of the EES business. At that time, Alcoa continued to shop the remaining electronics business and was in discussions with multiple parties.

    As of June, the electronics business had about 500 employees in three European countries. Two of those locations have been identified as Frickenhausen, Germany, and Mór, Hungary. AFL Stribel Production is the name that Alcoa chose to operate this business under.

    This is not the first time that Flextronics has sought to augment its automotive business by acquisition. In 2007, the company bought Sidler, a German ODM supplier of interior automotive products, out of bankruptcy. Flextronics intends to move the Sidler Automotive operation in Tübingen to the AFL Stribel location in Frickenhausen, according to a translated report on the tagblatt.de website of a local newspaper.

    Flextronics is also making connections with the automotive industry in another way. Delphi Automotive, the company that emerged from the Chapter 11 reorganization of the former Delphi Corporation, has appointed Flextronics CEO McNamara to Delphi Automotive’s new board of managers.

Kimball Electronics: a tier-two story

    Like Jabil, Kimball Electronics Group has many years of experience serving as a tier-two supplier to the automotive industry. But in contrast with Jabil, Kimball Electronics remains committed to automotive electronics as one of four segments that comprise its mix of business. Kimball Electronics focuses on assembling products with high durability requirements for medical, automotive, industrial and public safety applications.

    Earlier in the decade, Kimball Electronics was heavily dependent on revenue from the automotive segment. The provider decided to diversify and by spreading its revenue among the four segments was able to reduce its reliance on automotive sales.

By calendar year 2008, the automotive share of Kimball Electronics’ revenue had dropped to 30% from above 70% three years before.

    While Kimball has reduced its exposure to the automotive segment, an automotive tradition remains part of the company’s DNA. Automotive electronics work “is our heritage. It’s where we began. It’s the foundation of much of who we are today,” Kimball’s Chris Thyen told MMI.

    “Automotive has been and continues to be one of our primary focuses. Even though we have diversified, it doesn’t mean that we’re not committed to the automotive segment,” said Thyen. He added, “We have facilities in Europe, in North America and in Asia that are heavily focused on automotive. We don’t see that changing.”

    Thyen believes automotive electronics has a bright future based on the combination of several trends. One is the proliferation of electronics into applications such as stability control, vision and collision avoidance. Another is the continuing demand for communication and infotainment systems and conveniences such as power windows and gates. Yet another trend involves the conversion to an electric drive train in green vehicles of the future. Finally, the expected boom in auto sales in China and other emerging markets will also fuel the demand for electronics.

    Kimball is encouraged by what it has seen of future product designs by tier-one customers. Given what is on customers’ drawing boards, “it just looks very, very promising as far as potential revenue goes in the automotive segment,” said Thyen.

    The provider recently generated some positive momentum in its automotive segment revenue. Its sales in the segment increased sequentially over the last two quarters.

    With over 100 million automotive electronics modules to its credit, Kimball supports a wide range of automotive products. Among them are braking ECUs (electronic control units), stability control ECUs, infotainment systems, telematics, video camera systems and navigation systems. Earlier this year, Kimball won a program to manufacture ignition sensing and control products for vehicle platforms in Europe. A short time later, the provider landed a contract from an existing North American customer to produce Bluetooth hands-free radio devices at an annual volume expected to exceed 500,000 units.

    But Kimball doesn’t pursue every automotive opportunity that comes down the pike. “We’re pretty selective about the partners we engage with,” said Thyen. “We want to know what car platforms the product is going onto. We want to understand what the technology is, where it is in its lifecycle, whether deployment may be growing or accelerating,” said Thyen. Kimball’s evaluation also includes ascertaining the financial stability of a potential customer.

    Thyen believes that the financial crisis in many cases has made tier-one companies more dependent on their tier-two providers. Forced to cut capacity and capabilities, these tier ones “are leveraging their partners to provide something they may have provided,” he noted. As a result, Thyen foresees much less shopping around among tier ones than in the past and greater value placed on existing relationships.

EMS and ODM Convergence?

(Editor's Last Word, September 2009)

    In recent years, some industry observers have predicted a merger of the EMS and ODM sectors of the electronics outsourcing space. This scenario gained some exposure in July when Digitimes, a Taiwan-based website, reported Acer founder Stan Shih as saying that the distinction between EMS providers and ODMs will eventually fade away. Shih reportedly foresees that the two types of outsourcing providers will blend into a new category called design manufacturing services, or DMS. MMI believes that this view has some validity but overstates the case for sector convergence.
    There is no question that overlap between the EMS and ODM sectors is taking place within the two largest companies in the EMS industry. Both Hon Hai and Flextronics have made well-publicized thrusts into the ODM notebook space. On the ODM side, companies continue to diversify into product areas that EMS providers also pursue. Furthermore, the service offerings in the two sectors become blurred when joint design projects are considered.
    But MMI continues to believe that a full-scale merger of the two sectors is not in the cards for the foreseeable future even though some providers have embraced both models (Jan. 2008, p. 5). For one thing, only the largest EMS providers can afford to invest in ODM platform designs on spec. For another, there are past cases of providers putting together an ODM product offering, only to withdraw it later on. It is questionable whether these providers would do so again.
    For convergence to occur, both sides must move toward a new norm. But, other than in a few pre-existing cases, there is little evidence that ODMs are interested in moving in the EMS direction. If they were, the time to do it would have been during the last 12 months when EMS valuations were bottoming out and the cost to acquire an EMS provider was at a low point. Not a single ODM took this opportunity to snap up an EMS company. Why? MMI believes that ODMs for the most part want to avoid the EMS model, which involves managing more customers, products and parts than a typical ODM has and at potentially lower profit margins. What’s more, ODM growth rates in recent years have outpaced those of the EMS industry. This fact gives ODMs another reason to stay out of the EMS business.
    While the ODM model works for high-volume, commodity-like products, applying it to high-mix products of lower volumes is problematic. That’s because the volumes of these products are often not large enough to amortize ODM design and development costs. Still, in the high-mix arena there are EMS providers who will take on full product design projects, but only when paid upfront for their efforts.
    Although the two largest EMS providers have expanded into the ODM space, ODMs have not returned the favor. And large numbers of EMS companies have good reasons not to follow their leaders into the ODM business.

Copyright 2009 JBT Communications. Copying, posting, publishing or distributing these articles without permission is prohibited.

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