Forbes 4/30/01

Some famous entrepreneurs failed spectacularly trying to start car companies from scratch. Preston Tucker brought out the Tucker in 1946 and went bankrupt three years later. John DeLorean had his gull-wing sports car and failed in 1982. Henry J. Kaiser could only produce his beloved Henry J. from 1952 until 1954.

Now Robert A. Lutz, the former vice chairman of Chrysler and a 35-year veteran of the auto industry, has started Cunningham Motor Co. He aims to deliver a sexy sports coupe with a 600hp engine and a $250,000 price tag sometime in 2004. The car will be called the Cunningham C-7, after America's postwar racing legend, Briggs Cunningham Jr., whose son is Lutz's partner. Lutz is showing off a prototype now and is rounding up venture capital.

Does Lutz have a prayer of succeeding? He does because, unlike those other three would-be carmakers, he will put not a penny into a factory. Cunningham Motor will farm out production to some outsider, most likely a car parts maker. The design, engineering and even most of the retailing will be contracted out. Lutz, an ex-Marine who flies fighter jets for fun, plans just 20 employees for a company with targeted annual revenue of $100 million.

"Cunningham will be the world's most virtually integrated car company," says Lutz. His role is more movie producer than manufacturing mogul: "You have the idea for the movie. You give them the money, and you've signed off on the script."

Times have changed since Henry Ford made the River Rouge complex in Dearborn, Mich. into the ultimate in vertical integration, with iron ore going in at one end and shiny Model A's coming out the other. Now vertical dis-integration is the order of the day—in autos, in handheld computers, in pharmaceuticals, in ink-jet printers, in health foods, in cameras. The company with the brand name or a clever marketing idea isn't necessarily the one with the factory. Why put capital into a factory when you can put it into something much more valuable—like a brand?

The whole personal computer era can be seen as one giant triumph of dis-integration, as IBM's (nyse: IBM - news - people) circuit-boards-to-boxes-to-software mainframe business gave way to the layered computer industry we see today: Intel making the electronics, Dell the boxes and Microsoft the software. Taking this dis-integration a step further, many firms selling electronic appliances are outsourcing large chunks of their manufacturing. Lucent Technology is handing off $8 billion worth of its manufacturing to outside parties, about 45% of its output. Rival Cisco Systems (nyse: CSCO - news - people), though it does have four of its own factories, was committed from its infancy to going outside. Now all of its subassembly manufacturing and 42% of final assembly of its switches and routers are done by a variety of the largest contract manufacturers. Nearly 80% of Kodak's reloadable cameras and all of its digital cameras are sourced in Asia.

Compaq Computer (nyse: CPQ - news - people) makes only about 10% of the computers it sells to consumers. It relies on an outside provider to field a chunk of its customer service calls and had a Taiwanese firm, HTC, help design its iPaq pocket computer. Nearly all of Hewlett-Packard's printers are made by someone else. So are the majority of HP's calculators, PCs and low-end servers. The company even outsources some of its sales and marketing efforts. Engineering is what defines this company, not workers in hair nets picking tiny screws out of parts bins. Says Corey Billington, vice president for HP's sourcing: "We don't think we gain competitive advantage by driving forklifts faster."

Outsourcing has been around for a while—witness the Coca-Cola Co. (nyse: KO - news - people), which has for decades enjoyed a particularly handsome return on capital because it has outsourced the machinery-intensive bottling work to other entities. Yet there is no mistaking the trend. Whereas the 20th century was one in which vertically integrated companies were powerful, the 21st is the century of virtual companies. But why? Why is it that so many manufacturers have recently taken a dislike to factory work? There are three reasons.

One is that, to a degree that was not true in Henry Ford's day, the money is in the brands, not in the machinery. Hewlett-Packard's tangible book value—its factories, inventories and receivables, minus liabilities—is $14.5 billion. Its market value is $58 billion, four times as much. Wall Street is saying that engineering, brand recognition and other intangibles are together worth three times as much as assets you can see and touch. The phenomenon is not peculiar to this company. The ratio of price to tangible book value for the S&P 500 is 7.1; that is 6 times what the ratio was in 1979, according to Standard & Poors.

Next reason for the growth of outsourcing: globalization. No surprise that contract manufacturers for electronic gear have sprung up in Malaysia and China, where skill levels are high but labor costs only one-fourth what it does in the U.S. In Detroit the outsourcing may begin with a transfer of work from a unionized big three plant (total labor cost, more than $53 an hour) to a unionized but economically weaker parts company (where the UAW can extract only $26 an hour). The next stage is the shift of work to Mexico ($2.50 an hour). GM's former parts-making subsidiary, Delphi, which opened its first plant in Mexico in 1978, now has 55 plants there.

Third reason not to own a factory: Only the biggest companies can keep it busy enough. That doesn't explain what Ford Motor is up to, but it definitely explains Cunningham. Lutz hopes to sell 400 of his luxury cars a year; a car a day does not make an efficient assembly line. Hain Celestial, the natural foods outfit, has other manufacturers produce 45% of its sales. Revenues total only $400 million spread across 2,500 products, so it needs to go outside to get economies of scale.

Henry Ford made his own tires, steel and glass. Ford Motor (nyse: F - news - people), now running in the other direction, spun off its parts-making operation, Visteon, last summer, then hired that company to supply 25% of the 2002 Ford Explorer, including a fully assembled dashboard, the rear axle, the fuel tank and the carpets. Says Ford Chief Executive Jacques Nasser: "I don't think a customer minds, as long as the particular component or system is true to the brand values." The Visteon deal shaved off over $1.5 billion of assets. Nasser is putting Ford's capital elsewhere, spending $9 billion to buy just two intangibles, the names Jaguar and Volvo.

General Motors (nyse: GM - news - people) will soon just be making the outside and underbodies of its cars and trucks; it is putting various auto supply companies in charge of the interior of each of its vehicles. Some of GM's 1,100 engineers now working on car interiors will move to desks at suppliers' offices. GM didn't even bother to design and engineer the Chevrolet SSR pickup it will start selling late next year. Instead, it farmed that work out to ASC Inc., a Detroit-area auto supplier that will help train workers at the GM factory where the 15,000 Chevys will be built each year. Workers assembling the Mercedes M-class in Vance, Ala. build just 20% of the sport utility vehicle. The rest comes in big pieces ready-made by suppliers and trucked to the assembly line, where Mercedes workers bolt them on.

In his day job Bob Lutz is chief executive of battery maker Exide, where he is on the other end of the outsourcing movement. Lear, a $14.1 billion auto supplier, has hired Exide to help package its batteries within the interior modules that Lear is selling to automakers. This trend led Exide, with $3 billion in revenue, to design the Exide Select Orbital battery, a battery shaped like a six-pack of beer that can be configured to fit in tight spaces under the hood or inside the vehicle. Another auto supplier, $1.1 billion MSX International, is growing fast by acting more like a consulting firm for the auto industry. It supplies engineers, not camshafts, to the world's automakers, and increasingly takes on outsourced projects in the telecommunications and health care industries.

Outsourcing, which once meant mainly the simple offloading of auxiliary activities like groundskeeping, the corporate canteen or the data processing center, is very different today. It now entails what are—or once were—a business' core activities. "It's a case of the vertical business model dies and another one begins," says Eugene Polistuk, chief executive of Toronto-based Celestica (nyse: CLS - news - people), one of the new breed of contract manufacturers that dominates electronics products.

There has long been a place for private-label or house-brand makers of everything from washing machines to mayonnaise—sometimes the brand companies themselves would peddle excess output that way. But now it's the premium-label products themselves being ghosted. And in technology that's pretty advanced stuff. Swedish telecom giant Ericsson (nasdaq: ERICY - news - people) made news in January by opting to farm out an estimated $3 billion worth of mobile phone sets. At the service end Verizon, AT&T and Sprint now use contract help in some cases to deploy and manage their cellular phone networks.

The surge in outsourcing has made fortunes for shareholders in companies like Solectron (nyse: SLR - news - people) in Milpitas, Calif. and Flextronics International (nasdaq: FLEX - news - people) in Singapore. Despite the recent deflation in the technology sector, Solectron's stock—to the delight of finance chief Susan Wang— is up seventyfold since 1990. "We're still in the early stages of growth in manufacturing outsourcing," says Lehman Brothers analyst Louis Miscioscia, who sees the value of outsourced electronics goods more than doubling to $280 billion three years from now. The chief executive of Sweden's Electrolux, Michael Treschow, has told analysts he'd like to get out of building refrigerators, if only there were an independent supplier.

No surprise, many brand-name companies are shy about the fact that they touch their own products so lightly. You don't see Sun Microsystems, Apple Computer and Gateway as well as food producer and apparel-maker Sara Lee and drug star GlaxoSmithKline—all of which outsource a healthy portion of their production or activities—talking about this aspect of their business. Even companies that are proud of handing off work, like Dell Computer, withhold most details.

In the pharmaceuticals industry outsourcing has become a $30 billion business, according to consulting firm Arthur D. Little. About half that sum goes to manufacturing firms like Greenville, N.C.-based DSM Catalytica, which offer both chemical ingredients and finished products, including cartons, bottles and packaging. A good chunk of the rest flows to contract research organizations like Quintiles Transnational (nasdaq: QTRN - news - people) in Durham, N.C. and Covance (nyse: CVD - news - people) in Princeton, N.J., which test and market drugs. Quintiles, which had revenues last year of $1.66 billion, manages 9% of all the clinical trials done worldwide.

Though generic firms and new companies tend to outsource more than Big Pharma, the practice is growing there, too. Among DSM Catalytica's clients are Pfizer, Merck and GlaxoSmith-Kline. Quintiles and Covance both do work for the world's 50 largest drug companies.


One driver is Big Pharma's desire to reduce expenditure on fixed assets. "Imagine you're a big pharmaceutical company with three drugs in late-stage trials and the next year you have none," explains J.P. Morgan H&Q analyst Ken Miller. Expanding or launching capacity in-house involves recruiting, training and stationing employees. Quintiles and Covance are there to absorb the ebb and flow. They cut time to market, too. Whereas it might take a large pharmaceutical firm 18 months to recruit 500 patients for a study, "we do it in 6 months," says Quintiles Chairman Dennis Gillings. That adds one more year that the brand owner can be selling on a 20-year patent.

It's no secret that the footwear and apparel sectors contract widely—working conditions at subcontractors often attract unfavorable notice. For all the sweatshop noise, the rag trade knew this setup made sense long ago—it never occurred to the Gap to hire an apparel worker. Nor is it a surprise that companies like Mattel and Hasbro get most of their toys from outside factories, many in Asia. But did you know that about half of Samuel Adams beer comes from contract brewers (and that parent Boston Brewing produces on contract for two other brands)? And, in the financial realm, that the company behind PNC and First Union credit cards is giant MBNA? Cincinnati-based Redox, a virtual detergent-maker that acquired lesser Procter & Gamble brands like Oxydol and Biz, relies on contract manufacturers such as Korex in Michigan, which in turn also produces for other big laundry brands.

So-called fabless semiconductor companies—like Altera and Xilinx—arose in the 1980s to design specialized chips while leaving the wafer line-work to all-purpose foundries in Taiwan and elsewhere. Cisco Systems was a pioneer in fabless electronic gear, taking advantage of the Internet to connect customer orders directly to the shipping docks of its contract manufacturers. Handspring (nasdaq: HAND - news - people), the company behind the Visor personal digital assistant, followed the Cisco model from the start: it has no factories of its own. None of its employees has any physical contact with products. When orders for Visors come in over the Web site (which is hosted by yet another firm), the information is fed first to its fulfillment partner, which keeps the inventory, and then directly to Handspring's contract manufacturers, Flextronics and Solectron, which also package and ship the product. To make it all work smoothly, Handspring brought in the contract manufacturers while designing the Visor. Result: The breakthrough product hit the market only 15 months after the company was founded.

Leveraging resources? "We're projecting revenues this year of $400 million, and we only have 400 employees," says a Handspring spokesman. "When our Chief Executive Donna Dubinsky was at Apple Computer, they had 1,500 employees and half the revenue."

But the main reason to outsource is the imperative to do what you do best—what economists call comparative advantage. Fifteen years ago Ericsson was still designing and manufacturing the screws that went into its wireless phones. "Nobody would imagine doing anything like that today," asserts Björn Boström, Ericsson's senior vice president of supply and data processing. Of course not. Spend too much time on screws and some competitor will score a hit with a cooler handset.

Henry Ford happened to be a manufacturing genius, but he was not particularly adept at judging customers' needs. What's Bob Lutz good at? He has a wizard's touch for marketing, he has impeccable taste in cars and he is so well-connected in the auto industry he can tap into whatever talent he needs. Factory layouts are for someone else to worry about.

Meeting The Makers
Kerry A. Dolan and Andrew Tanzer, Forbes Magazine, 04.30.01

Once considered a safe technology play, the contract manufacturing sector has hit the skids. It may soon be a good time to invest.

Talk about a contrast. Over the last four months, while the Nasdaq tumbled below 2000 and spending on technology spiraled downward, the contract manufacturing sector appeared unstoppable. Companies like Singapore- headquartered Flextronics International and St. Petersburg, Fla.-based Jabil Circuit were signing billion-dollar deals on what seemed like a weekly basis to make mobile phones for Motorola and Ericsson and communications gear for U.K. giant Marconi.

And then reality hit. In the past two months Solectron, the biggest of these contract manufacturers—also known as electronic manufacturing service, or EMS, companies—announced it would miss analysts' revenue targets for the current quarter and lay off 9,000 employees, 11% of its work force. Competitor Jabil Circuit's chief executive, Timothy Main, warned analysts that earnings would drop and that demand was so unpredictable he couldn't say what the summer quarter would bring.

End of story? Unlikely. The six biggest EMS companies, (see table) are now feeling the pain as their customers' sales suddenly slow and as these same brandholders work off bloated inventories. But the long-term trend is in the contract manufacturers' favor—and the current electronics slump will likely accelerate the relentless push to outsource.

Vertically integrated electronics firms will continue to off-load the production process (see story, p. 106). "Everything is focused on how you squeeze costs out of the equation," reasons Ed Rodriguez, head of KPMG's electronics practice. Deutsche Banc Alex. Brown's Christopher Whitmore projects that, globally, the ratio of electronics output that is outsourced will double to 30% over the next few years and eventually top 50%, a migration of hundreds of billions of dollars in production. This year alone the percentage of cell phone handsets outsourced will surge from 10% to as much as 18%, predicts Whitmore.

The economics are compelling for vertically integrated electronics companies such as Motorola and Compaq. Outsourcing enables them to shed factories and to shift manufacturing from a fixed-cost to a variable-cost structure. In slack times, such as now, these companies have too much capacity; in peak periods they lack capacity. By outsourcing, the electronics giants can handle the manufacturing challenge of short product-life-cycles more flexibly and focus on their core competencies of design, sales and brand management.

Since manufacturing is the EMS firms' primary focus, they can usually do it more cheaply than their customers. With worldwide assembly operations in low-cost regional bases such as China, Mexico and Hungary, they can also supply multinationals' global markets. They are honing measures of manufacturing efficiency—such as inventory turns, asset intensity and demand-flow technology—to a science. While brandholders may build only a single product in an in-house factory, an EMS supplier spreads risk by serving multiple customers from one plant.

So in recent months a steady stream of electronics firms has announced outsourcing deals. In December Motorola reported it would sell two factories to Celestica and outsource $1 billion worth of mobile phones and other devices over three years to the Canadian firm. This after last May when Motorola signed away to Flextronics 15% of all manufacturing in its communications enterprise division—a five-year, $30 billion deal.

One new growth driver over the next couple of years will be Japanese electronics manufacturers, an emerging market for the EMS industry. The Japanese account for 25% to 30% of the world's electronics output but are the last to outsource. Ash Bhardwaj, Flextronics' president of the Asia Pacific division, notes that while Sony does wonderful product development and has one of the strongest brands in the world, it still earns puny profits from manufacturing. In recent months Sony sold consumer electronics plants in Japan and Taiwan to Solectron, and Flextronics won business from Toshiba and Epson in eastern Europe.

Of the six biggest EMS firms, Lehman Brothers analyst Louis Miscioscia favors Flextronics and Celestica. Both have landed fat contracts: Flextronics with Microsoft for its Xbox game console and with Ericsson for an estimated $3 billion worth of mobile phones; and Celestica with a $4 billion deal with communications and software maker Avaya (formerly part of Lucent). Deutsche Banc's Whitmore prefers the same pair. One reason he likes Flextronics is the firm's solid footprint in Asia, especially China and Malaysia, which, with their low-cost labor and developed parts-supply chains, are the world's most competitive suppliers of many electronics products. Flextronics is strongly positioned within the booming Chinese market, where it makes cell phones for customers such as Nokia, Alcatel and Motorola.

Visibility in the end market is currently dismal. But the long-term trend to outsource is still intact.

Hands Behind The Brands
04.30.01 Meeting The Makers

These stocks have taken a bath with the rest of the technology sector, but will likely pick up more business once their customers work through excess inventories and look to cut costs further.
	PRICE
Company	recent	52-week high	sales ($mil)	P/E (latest 12 mos)
Celestica	$24.60	$87.00	$9,752	24.4
Flextronics	13.00	44.91	10,423	NM
Jabil Circuit	19.15	68.00	4,371	20.6
Sanmina	18.56	60.50	4,842	21.1
SCI Systems	16.84	65.13	9,147	11.6
Solectron	16.89	52.63	16,884	17.1
Prices as of Apr. 3. NM: Not meaningful. Sources: Market Guide and Interactive Data Corp. via FactSet Research Systems.