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Hon Hai’s Annual Meeting Provides Signposts for a Changed Contract Manufacturing and Value-Chain Model

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The following commentary can also be viewed and commented upon on the Supply Chain Expert Community web site.

Last week, AMR Research / Gartner announced the 2011 slate for the Top 25 Supply Chains and to no surprise, Apple was designated as number one in supply chain capability by a wide margin.

Who can contest Apple’s continual capabilities to ship millions of product units each and every quarter from a primarily outsourced value-chain and strategic commodity procurement model.  Achieving 70 percent jumps in profit margins is also a significant feat that many a company continues to envy.

The other side of Apple, however, stems from its dominant contract production arm, Hon Hai Precision Industry Co., and its Foxconn International Holdings Ltd. contract manufacturing division which represents Apple’s and other high tech OEM’s de-facto production presence.  This week, Hon Hai held its annual meeting and there were important strategic messages for high tech and other industry players to contemplate, namely that the high-volume contract manufacturing business model motivated by purely a low-cost labor and asset-shift model will have to change.

Hon Hai Chairman Terry Gau told assembled reporters that the company’s long-term direction was to continue to develop more technology prowess.  A direct quote: “We are a high-tech manufacturer, not a contract manufacturer.” Last quarter, a cover story featured in Bloomberg Businessweek outlined exactly what that means in product and process design capabilities. Foxconn capabilities already include toolmakers, mold and die makers and process specialists that can quickly take a product design to volume ramp-up. The reason, of course, is that Foxconn makes far more money on parts and developed technologies vs. assembly of iPhones and iPads.

Business margins remain difficult.  Reuters notes that Hon Hai’s operating margin has dropped to 2.87 percent in 2010 from 5.43 percent in 2005. The company has now posted two quarters of declining profits because of higher labor costs in China and burden incurred for relocating production to more interior regions of China where labor costs are lower and production facilities can be operated with a different, less dormitory-like operating model. Rumors are swirling that Apple has goals to ramp-up this year’s existing iPad production levels to over 10 million units per quarter and both Gau and other Apple suppliers acknowledge that tablets are currently challenging to make at higher volumes.

For high-tech volume manufacturing, Gau acknowledged that many more Japan based, brand-oriented high tech companies such as Sharp, Cannon and Hitachi are abandoning their in-house production models and will continue to provide Hon Hai more opportunities for volume growth.  However, the company’s future profitability growth lies in more upstream vertical integration in high tech value-chains.  As an example, Hon Hai recently setup a joint venture with Sharp to develop more advanced LCD technology.

The company has plans to invest in operating models that support customer needs for more geographic in-sourcing needs, as well as the lower-cost labor manufacturing model.  In geography presence, Hon Hai plans to invest $12 billion in Brazil over the next five years to support rising demand for tablet computers across Latin America. The company also indicated its intent to invest in production facilities on the African continent.  No doubt, that signals intent to tap additional sources of low-cost labor.

As Hon Hai continues to invest and develop both advanced technology and high volume production process capabilities that extend further along high tech value-chain, it will increasingly find itself in competition with current tiered suppliers including the large Korean based global suppliers. Apple and other high tech OEM’s will have to face the reality that they cannot place a majority dependency on Hon Hai as a singular production services provider for fear of locking-out other major suppliers, or fostering a major global competitor.

Supply Chain Matters had previously commented that if you accept the notion that high tech and consumer electronics value-chains can be the bellwether of what is to come, than the high volume contract manufacturing model driven by lower-cost labor has run its course and a different model will emerge, one that will provide more interesting dynamics in vertical integration and changing roles in the months to come.

OEM’s may well run the risk of outsourcing too much of core capabilities if they believe that outsourcing of manufacturing is just an asset avoidance strategy. CEO’s and CFO’s would be wise to keep an open dialogue with their senior supply chain and sourcing executives as well as industry observers.

Bob Ferrari

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