As far back as 2011, this analyst began to share observations on a growing reality of a changed model of contract manufacturing services (CMS) among high tech and consumer electronics supply chains. The reasons were obvious five years ago, and far more obvious today. The ability to continually experience a mere one to two percent in operating margins, regardless of volume scale, was unsustainable in a strategic window. Once more, with direct labor costs increasing in major manufacturing hubs across China and other areas, and with technology cycles changing more quickly, the need for constant capital infusion in investments in the newest technologies and automation further requires an increased return for such investments. Remember that the CMS model evolved from a need by OEM’s to avoid the need to invest in manufacturing assets and process automation.
CMS firms such as Hon Hai Precision (Foxconn Technology) have been steadily executing a diversification strategy. In the case of Foxconn, the world’s largest contract manufacturer, it includes entry into consumer component and electronics, as well as service sectors serving China’s and greater Asia’s growing middle class. In our last published Supply Chain Matters commentary, we highlighted a report that Hon Hai may well be on the verge of a tie-in with Sharp’s LCD flat screen unit, opening the door for broader high tech value chain integration.
We now call reader attention to this week’s edition of Bloomberg BusinessWeek, that includes the article: The Foxconn of Bathroom Scales. This article describes how Flextronics, now renamed Flex, after spending in excess of 40 years as a low-margin CMS, is re-making itself as a leading manufacturer in a new ecosystem Internet Of Things (IoT) enabled products.
The article astutely observes: “Building stuff for startups and non-tech companies is a lot more profitable than trying to satisfy giants such as Apple and Cisco, which have squeezed contract manufacturers’ margins to 2 percent.”
Flex’s mission is to become to go-to manufacturer for connected products. That would include products ranging from sneaker mounted wireless charges, clothing embedded with sensors that monitor all sorts of body functions, to driverless farm equipment or smart shelves for retail outlets. Its Innovation unit has opened 23 R&D labs where startups and up and coming companies can work with designers and utilize 3D printers and manufacturing equipment to develop new product prototypes. Flex’s design teams have created a library of 130 reusable component designs to help start-up companies to develop IoT related products more quickly and move these products to volume manufacturing and/or service needs.
Bloomberg observes that Flex’s business is growing with clients such as Ford, Fitbit, Johnson & Johnson, and Whirlpool, but perhaps not fast enough to avoid getting crushed by other large manufacturers. The report ends with a quote from a consultant: “If you aren’t getting 50 percent of your revenues outside of traditional electronics, please contact us, and we’ll help you liquidate your assets.”
While a rather blunt and self-serving statement, it does reflect that the traditional CMS model within the high-tech industry will change.
CMS providers have no choice but to move their services models either further up the electronics value-chain, within our consumer service areas, or virtual engineering and manufacturing support and services in areas beyond today’s traditional consumer electronics areas.
For the CMS sector, change is a definite factor. The question will be which firm makes the most successful transition. Meanwhile, high-tech OEM buyers and strategic sourcing teams should best be thinking of the consequences, and the implications.
Our high tech and consumer electronics supply chain readers may recall that Japan’s Sharp Corp., and specifically its LCD screen business unit has had months of financial struggle. One of the important significant factors related to Sharp is that it serves as one of the four Liquid Crystal Display (LCD) and flat panel screen suppliers to Apple, including screen supplier for the iPhone. Sharp has had a track record of innovation in LCD technology but a rather rocky financial history as well
This week, Reuters is reporting that its informed sources indicate that tie-up talks involving contract manufacturer Hon Hai Precision (aka Foxconn Technology) are now in-progress. The Financial Times also published a similar report. Hon Hai declined any request for comment by Reuters and FT.
Initial talks between Hon Hai and Sharp actually began in 2011, after both firms had established a joint technology partnership. In 2012, there were many business and social media reports indicating that Hon Hai was prepared to take an equity stake in Sharp’s LCD development and factory operations, but with implications that Hon Hai would become Sharp’s largest shareholder and have the ability to assume some strategic management control of Sharp. A further implication was that Apple, through its relationship with Hon Hai and Foxconn, was willing to invest in Sharp’s longer term supply, but that component strategies would cede to Hon Hai. The Hon Hai investment did not occur in 2012, because of Sharp’s deteriorating stock price and the threat of too much outside control.
During that same period, Japan’s Sony Corporation, Toshiba Corporation, and Hitachi Ltd. together merged their money-losing small LCD display operations to form a single company, Japan Display, backed by $2.6 billion of funding from Innovation Network Corp. of Japan, a government backed agency. Japan Display is currently another of the LCD component suppliers to Apple, and the combined operations and infusion of significant new capital likely cemented that relationship.
According to this week’s Reuters report, the latest proposed tie-up would spin-off Sharp’s display unit and possibly includes additional cash injections from other outside entities such as the state-directed Innovation Network Corp.
The two firms continue to jointly operate the advanced large LCD production facility located in Western Japan.
Interesting enough, in 2012, Apple rival Samsung opted to provide a $110 million lifeline investment for Sharp. The deal was reported to provide Samsung with a 3 percent stake, along with gaining access to leading-edge IGZO display and other technology. Business media reports at the time speculated that Samsung’s investment was an attempt to stem Apple’s strategic influence on Sharp.
In late June, Supply Chain Matters called attention to a published report from The Wall Street Journal indicating that Sharp senior management had struck a last-minute deal with the firm’s bankers to provide an additional $1 billion plus lifeline, the second in three years, in exchange for restructuring measures that included exiting the North American television market and a 10 percent workforce reduction. Also noted were the market prices for LCD panels remain in significant decline as other suppliers turn more to China based smartphone manufacturers for revenue needs. The WSJ cited data stemming from market research firm IHS indicating that 5 inch HD smartphone panel components prices have dropped nearly 60 percent from Q1 2013 through mid-year.
This legacy of Sharp represents the perils for being a leading-edge LCD technology provider in today’s high tech and consumer electronics sector. Product OEM’s such as Apple and others demand the latest breakthroughs in technology and more automated manufacturing processes, in return for orders representing volume scale. However, in a technology area where multiple suppliers fiercely compete for the same high-volume OEM business, and a cutthroat environment where severe amplitudes of supply and demand imbalances force prices to dive quickly, the need for constant capital becomes paramount. That may be the legacy of Sharp’s LCD unit.
If this reported tie-up were to occur, it would provide another significant milestone in Hon Hai’s prior strategic plan to move away from a sole focus on the slim margins of contract manufacturing, and more towards a supply chain vertically integrated high-tech and consumer products manufacturer that can control multiple key component supply tiers.
This week’s edition of Bloomberg BusinessWeek features a timely but sober update indicating that: Things Are About to Get Ugly at Kraft.
Not only does this report indicate that change is already already underway for Kraft, it provides more sobering indicators of expected erosion in other associated industry business and supply chain capabilities in the months to come.
We are Supply Chain Matters have featured a number of commentaries related to Kraft and its associated supply chain capabilities since our inception in 2008. That includes its split in 2012 into two separate companies, Kraft and Mondelez International. We have done so because of our belief that this global CPG giant was a true barometer of the significant market and industry forces impacting what is increasingly being termed as “Big Food” today.
In 2009, Irene Rosenfeld, the CEO of Kraft at that time, indicated to The Wall Street Journal that “scale is a source of great competitive advantage” in terms of industry growth and innovation. That motivation probably led to the acquisition of Cadbury. Eighteen months later, Ms. Rosenfeld, along with Wall Street partners, orchestrated a massive corporate split, carving out Mondelez as a $30 billion focused snacks company with the most attractive prospects for global growth, particularly in emerging consumer markets.
The $18 billion North America focused grocery brands business was to be Kraft Foods which literally was forced to develop its own separate supply chain and business support systems.
Prior to the split, Kraft corporate had reportedly invested $700 million in a global rollout of a singular SAP ERP system. All of the assumptions that made-up that implementation suddenly changed.
This corporate split further implied two different supply chain business support and distribution models. Snack food and cookie consumers are impulse buyers, with promotions, market timing and inventory deployment strategies requiring sophistication and proper timing. The distribution model is focused on higher touch including direct to store service needs of convenience stores and smaller retail, particularly when emerging consumer markets are considered. Grocery, on the other hand, was a model of conservative sales growth but high scale and distribution volume. Much of the grocery customer base was large supermarkets, with emerging penetration among smaller retail and convenience stores. Grocery implied a high dependency on vendor managed inventory and responsive replenishment business replenishment. We again bring these tenets out, because they provide more context as to what existed and to what is now occurring.
In September of 2013, we praised the positive transformation and new leadership that was underway at split Kraft Foods. Former Procter & Gamble supply chain executive Bob Gorski was recruited to lead a dramatic transformation. In an industry conference presentation we viewed at the time, Gorski described product demand and supply processes touching literally 60 different times with little effect on forecast accuracy. Supply chain wide metrics were at odds with individual plant and functional metrics, some in direct conflict. There was a lack of a fixed execution planning window with 60 percent of plan changes occurring in the execution window. Production lines, on average, were forced to shutdown every 4 minutes because of various maintenance or setup issues due to inconsistent process specifications. Gorski articulated a goal as moving from metrics in isolation to metrics as part of a performance culture. Oh yes, adding to the challenge was a need for Kraft grocery to adopt a new supply chain software support system and more responsive technology enabled decision-making.
In March of this year, the industry was taken back with the news that H.J. Heinz would merge with Kraft Foods in a combined public company that was named Kraft Heinz Company. It creates what is anticipated to be the world’s third largest food and fifth largest beverage company featuring many well-known consumer brands. This deal was backed by infamous private equity firm 3G Capital Partners, and the financing of Warren Buffet’s Berkshire Hathaway, which each contributed $5 billion in financing. Together, bot investors own 51 percent of outstanding equity.
The latest Bloomberg article essentially opines that in the end, the Kraft-Heinz deal has little to do with market growth and a lot to do with cutting costs. That includes targeting an additional $1.5 billion reduction in annual costs before 2018 and according to the article: “The company will lose employees, whole levels of management, and maybe a few brands, too.” It cites as a reference a February 2015 McKinsey report which describes 3G Capital’s strategy as acquiring marquee brands that need operational improvement, and then “purging existing culture and management teams” while employing zero-based budgeting techniques requiring departments to justify every expenditure, and squeezing suppliers for similar cost savings. McKinsey noted that Heinz itself has since its takeover, lost market share in 65 percent of its product categories, yet adjusted earnings have risen nearly 38 percent.
Bloomberg cites data indicating that with the prior Heinz merger, 90 percent of the senior executive team departed within three weeks and more than 7000 jobs, 20 percent of the then existing workforce was cut, along with closing of five factories. Thus far, after closing the Kraft-Heinz deal last month, 2500 job cuts have been announced including more than a third of the existing staffing at Kraft corporate headquarters. Further announced was that Kraft headquarters will be move from a 700,000 square foot complex of a Chicago suburb to a 170,000 square foot office in downtown Chicago. Travel has been restricted, conferences have been put on-hold and employees instructed to print double-sided.
To reinforce an overall industry concern, Bloomberg reminds us that Nestle Chairman Peter Brabeck-Letmathe had indicated earlier this year that Buffet and 3G have: “pulverized the food industry market, particularly in America, with serial acquisitions.” The Nestle executive additionally indicated that 3G’s “ruthless cost-cutting’, to improve profit margins has had a “revolutionary impact” on other food companies.
Parallel Impact- Mondelez
Today’s Business and Finance section of The Wall Street Journal features an updated report on Mondelez’s efforts at expanding market growth while attempting to reduce costs and improve margins. It observes that a second high-profile activist investor, William Ackman and his Pershing Square Capital Management firm revealed that it had built a $5.5 billion, 7.5 percent stake in the company, and cites sources as indicating a Pershing view that the snacks producer must cut costs significantly or sell itself to a rival. Activist Nelson Peltz of Train Fund Management joined the Mondelez Board in 2014 after a six month conflicting public debate on company strategy.
In emerging markets which currently account for 40 percent of existing Mondelez revenues, the company’s margins reportedly trail those of several rivals. The global snacks company has now reportedly engaged Accenture to implement zero-based budgeting techniques and a sweeping reorganization plan that is closing older factories in the U.S. and opening more efficient ones in lower-cost regions such as Mexico and Russia. The WSJ cites other equity analysts as engaging in debate as to whether the Nabisco brand use of direct-store delivery (DSD) in the U.S. should be curtailed or replaced for a lower-cost alternative.
Impact to Industry Supply Chain Capability
A fundamental belief in supply chain management is that supply chains exist to service customer needs and support required business strategic and tactical outcomes.
As activist actions continue to drive “Big Food” into modes of acute efficiency, cost-cutting and continued break-up and consolidation, the impact to supply chains invariable becomes destructive, risking the obliteration of previous gains in service, product quality, sustainability and process responsiveness. Once more, the tenets of supplier based product and process innovation are subsumed by other tactics to wring out additional cost reductions or more onerous payment terms.
While business and other industry media can for-tell of the pending ugliness that is circling Kraft, and perhaps Mondelez in the not too distant future, industry “Big-Food” supply chains risk a significant erosion of prior process, technology and other transformational gains as zero-based budgeting and wholesale cost-reduction efforts sap the energy of survivors. More importantly, the real objective for providing consumers with healthier, more sustainable food choices becomes subservient to an overriding short-term emphasis on increased margins and stockholder returns.
Hence is the legacy of activism, short-term results and the rest being damned. In the analogy of the wild kingdom, the weak in the herd are overtaken by predators, and soon the predators begin to overtake even the strong, as stamina is weakened.
One final editorial note: Our house has switched to French’s Ketchup. It is noted as free from high fructose corn syrup, artificial flavoring and preservatives and has a great taste. Hopefully, brands that have been around from the 1900’s will not succumb to the current madness surrounding “Big Food” and the wonton destruction of previous supply chain transformation initiatives, commitment to quality and commitment to talent and people development.
Many observers of commercial aerospace supply chains including Supply Chain Matters were anticipating forms of supply disruption and now we have a visible indication.
The Wall Street Journal reported today (paid subscription required) that a key supplier within Boeing’s 737 MAX program is wrestling with production ramp-up supply issues related to an engine thrust reverser. Difficulties in consistently manufacturing this part are apparently been flagged by Boeing as a significant development challenge for its commercial aircraft business.
According to the report, supplier GKN PLC will not be able to produce quantities of the new engine thrust reverser to support the ramp-up production needs of the newest version 737 MAX.
The problem is associated with the inner wall of the thrust reverser which is composed of a honeycomb titanium design to fit both size restrictions and withstand rather high engine temperatures. Key supplier Spirit AeroSystems transferred responsibility for working with component supplier GKN back to Boeing, because of the technical challenges.
The fact that volume production of the new thrust reverser is being flagged two years before planned first customer ship scheduled for 2017 is a good sign. However, as the article points out, initial prototype production is already underway including the wings, fuselage and new dedicated assembly line.
Boeing currently has firm orders for over 2800 of the new 737 MAX with plans to raise all models of 737 production volumes to 47 per month in 2017 and 52 per month in 2018. The 737 serves as the prime profitability engine for Boeing’s commercial business, hence it garners lots of attention.
The report indicates that Boeing executives have acknowledged the supplier and design challenge but indicate confidence that adequate resources and attention are being applied. A GKN spokeswoman declined comment to the WSJ and referred the question back to Boeing.
More than likely, there will be more supply challenges flagged for both Boeing and Airbus as each manufacturer strives to ramp-up production to unprecedented levels over the coming months and years. As always, the question will remain how each manufacturer responds to these challenges and proactively works with suppliers and design teams to resolve challenges on a timely basis.
Thirteen months ago, Supply Chain Matters called reader attention to the news that Boeing had reached a preliminary agreement to extend partnerships with a group of key Japan based suppliers to provide major structural components of the newly planned 777x aircraft. These suppliers provide major structural components such as fuselage sections, wings, and other components, and they involve parent companies Japan Aircraft Industries (JAI) and Japan Aircraft Development Corporation (JADC). Individual suppliers include:
Mitsubishi Heavy Industries Ltd.
Kawasaki Heavy Industries Ltd.
Fuji Heavy Industries Ltd.
ShinMaywa Industries Ltd.
Boeing has now announced that it has signed a formal agreement with these key strategic suppliers , which in aggregate will supply upwards of 21 percent of the major aircraft structure components for the planned new 777x model. The contract includes fuselage sections; center wing sections; pressure bulkhead; main landing gear wells; passenger, cargo and main landing gear doors; wing components and wing-body fairings.
In the Boeing press release, Boeing’s Vice President and GM of Supplier Management praises these Japanese partners for their commitment for working on the affordability goals associated to the 777X program. Judging on the interval of an entire year being required to finalize the supply agreement, we can all speculate on the back and forth negotiations. The JADC Chairmen and KHI President indicates in the release that the agreement involves investing in new facilities and introducing robotic and other automated systems. That may be the source of the negotiations and evolving production strategy.
Boeing notes that it has partnered with Japan based aerospace providers for nearly five decades, and that in 2014 alone, the company purchased more than $5 billion in goods and services. With the new supply agreement in-place, Boeing indicates it expects to purchase $36 billion of goods and services from Japan between 2014 and the end of the decade. From our lens, such a relationship is a testament to joint product design, component and production process innovation.
Teams have different definitions and context as to what may be termed strategic supplier. An overall spend of $5-$6 billion per year certainly qualifies for such a context.
Yesterday, after the stock market closed, Apple announced its fiscal third quarter financial performance and Wall Street’s headline was immediately one of disappointment. This was despite reporting that profits had surged 38 percent from the year earlier period along with total revenues that grew 33 percent. Gross margin was reported as a whopping 39.7 percent which is extraordinary for the majority of today’s consumer electronics providers. Yet within minutes of the earnings report, Apple’s shares plunged 7 percent in after-hours trading and today, dropped as low as 21 points before a small rebound.
What the investment community is primarily concerned with is a perception that Apple is trending toward a one-product company, that being the iPhone, which with the latest results, accounts for 63 percent of Apple’s overall sales. That is a ten percentage point increase from a year ago, prompting concerns that other products such as the iPad are declining in sales, while new products such as the Apple Watch have yet to provide an offset. Unit sales of the iPad are believed to have declined 18 percent in the latest quarter, making a sixth consecutive quarter of year-over-year declines. Once more, the previously touted partnership among Apple and IBM, designed to provide more business applications leveraging the Apple tablet, do not appear to be stemming the declining trend.
In the fiscal third quarter, while Apple reported shipping 47.5 million iPhones, an increase of 35 percent from the year earlier quarter, that number was 23 percent lower than shipped units reported for fiscal Q2. According to a report by The Wall Street Journal, analysts noted previous quarter-on-quarter iPhone volumes fell by 19 percent and 17 percent respectively, and remain concerned for a steeper rate of decline. Apple attributed unit shortfall to the lowering overall inventory by 600,000 units during the quarter. Fiscal Q3 has traditionally been Apple’s slowest volume quarter.
In an interview with the WSJ, CEO Tim Cook indicated that he refuses to accept the thinking that Apple cannot sustain its existing growth rates. He further indicated that Apple has pried open the door to untapped markets such as China, and that the company is sensing a larger conversion rate from Android powered devices to iPhone.
Apple did not provide any breakdown of Apple Watch performance but CEO Cook indicated to analysts that the “sell-through” of the Watch was better than the iPad and iPhone at their product introduction phases. We will have to wait and observe what that means over the next two critical quarters.
From our supply chain lens, the upcoming quarters will provide Apple’s planning teams with added challenges. Earlier this month, we highlighted that Apple is now actively planning the ramp-up of the planned next release of iPhone. Reports indicate that the company is requesting suppliers to support between 85 million and 95 million iPhones for the all-important end-of-year holiday buying season that ends at the end of December, This is despite anticipated modest hardware changes.
Planners are obviously reducing existing model inventories but must be diligent to not impact Apple fiscal Q4 results. With expectations for increased sales of the Watch, as well as a newly introduced iPod Nano, additional effort will be focused on ramp-up production milestones. An added challenge has got to be focused on what to plan for inventory and fulfillment needs for the iPad, given that there may well be a product change coming.
And then there is that mega “elephant in the room”, what to do with $200 plus billion in cash.
The adage for Apple’s and indeed many other global supply chain teams is often, not what you did yesterday, but what are you going to do tomorrow, next month, and next quarter.
Does that resonate?