TRADING WITH THE DRAGON, Part
1 Manufacturing that doesn't
compute By Tom Miller
BEIJING - Who has the biggest shopping
bags in China? Wal-Mart, America's largest chain
retailer, is well known for its voracity, sourcing
US$18 billion of merchandise from the country in
2004. Less well known and more telling is that
Dell, the world's biggest personal-computer (PC)
maker by sales, bought nearly $16 billion worth of
computer components from China in 2005, and this
year expects to spend $18 billion.
Dell's
numbers are revealing because they point to the
real story
of
the growth of China's export economy in the past
five years: it has been driven by the global PC
industry. Eight of the country's top 10 exporters
today are Taiwanese electronics companies
supplying branded PC sellers such as Dell with
unbranded computers and components.
Taiwanese original design manufacturers
(ODMs) - which, in contrast to original equipment
manufacturers (OEMs), contribute a significant
part of a product's design - dominate worldwide
computer manufacturing and have shifted virtually
all production to the mainland in the past five
years. Taiwanese notebook (laptop) computer makers
now manufacture almost 100% in mainland China,
according to Tony Tseng, an analyst with Merrill
Lynch in Taipei. In 2001, this figure was just 4%.
Today China assembles about 80% of the world's
notebook and desktop computers.
This
sounds like a significant move up the value chain
for China. Technology exports helped push China to
become No 3 in the world export rankings last
year, with telecommunications equipment,
electronic products and computers accounting for
43% of total shipments by value ($328 billion).
Yet there is, from the perspective of
China's development objectives, a problem: it is
foreign companies, not Chinese manufacturers, that
dominate almost all aspects of the computer
industry and capture its earnings. In 2005, not
only did foreign-invested companies account for
58% of total exports by value from China, they
controlled a remarkable 88% of exports in
high-tech categories.
The worldwide
computer industry is configured as a pyramid.
Microsoft and Intel sit at the top, rich in
intellectual capital and flush with profits. Below
them are the global PC brands - Dell, Apple,
Hewlett-Packard (HP), Sony - which turn a profit
through ruthlessly efficient product sourcing and
massive investment in marketing. They are supplied
with near-finished goods by Taiwanese ODMs with
factories on the mainland that receive components,
in turn, from thousands of smaller manufacturers,
many of them also Taiwanese-owned.
Almost
all mainland China brings to the industry is cheap
land and even cheaper labor. China is the
manufacturing center of the global computer
industry, yet it adds little value and therefore
makes little profit.
When the Taiwanese
government loosened restrictions on notebook
makers investing in the mainland in 2001,
thousands of ODMs jumped across the Taiwan Strait
to take advantage of lower production costs.
According to Jeffery Wu, an analyst at Los
Angeles-based consultancy iSuppli, labor costs in
the mainland are one-tenth of those in Taiwan,
while land and equipment costs are one-third.
Making a laptop computer is $20-$30
cheaper in mainland China than in Taiwan, says
Merrill's Tseng. In 2001, 30% of Taiwanese
electronics and other information-technology (IT)
companies had production facilities in the
mainland; now that figure is 70%.
The
global production base for desktops is the Pearl
River Delta (PRD) across the border from Hong
Kong, while the notebook industry is concentrated
in the Yangtze River Delta (YRD) around Shanghai.
Hon Hai Precision Industry, which makes desktop
computers and game consoles, employs 150,000
people in Shenzhen in the PRD and Kunshan in the
YRD; notebook maker Asustek Computer has 80,000
workers in Suzhou in the YRD, and Quanta - the
world's biggest notebook maker - 50,000 in
Shanghai. Local government officials claim that
1,500 Taiwanese electronics companies have
invested $12 billion in Suzhou alone.
All
basic PC assembly parts are made locally, mainly
by foreign-invested companies. Mid-range
components - LCD (liquid crystal display) panels,
hard drives, optical disk drives, memory chips -
are generally supplied by Taiwanese, Hong Kong,
South Korean or Japanese manufacturers that
increasingly have production facilities in
mainland China. Samsung, Panasonic and Hitachi all
make PC components in China.
Only the most
expensive part of a computer - the microprocessor,
or central processing unit (CPU), which costs
about $200 - is imported from the United States or
Japan, or added during final assembly, which may
take place outside China. Intel, which has about
an 80% share of the world CPU market, imports
chips because its technology is too sensitive to
be transferred to China, and uses its Chinese
factory mainly as a packaging and export base for
flash memory chips.
"The big winners in
the industry are the American companies,
especially Microsoft and Intel," said Tseng. "The
Taiwanese are making peanuts, with net profit
margins of just 2-3%."
In fact, the PC
industry as a whole is not particularly
profitable. Dell led the pack among the global PC
players with net profit margins of 6.7% in 2005,
though these are starting to slip, and Intel (22%)
and Microsoft (31%) remain the exceptions.
Margins at ODMs have fallen steeply as the
global PC brands ruthlessly play one off against
another to secure cheaper prices. Quanta's profit
margins actually fell when the company moved
production to China, from 10.3% in 2000 to just
3.7% in 2004. Yet profit margins are significantly
higher for many of the ODMs' components suppliers.
Tseng says that Asustek, which began life as a
components maker, maintains much higher profit
margins than other ODMs on the back of its still
highly profitable motherboard business.
The relationship between global PC brands
and their contract manufacturers is shrouded in
secrecy and bound by confidentiality agreements.
Leading PC and technology brand Apple is,
unsurprisingly, not keen to advertise the fact
that it employs somebody else to make its iconic
Macs and iPods. Apple refused to answer questions
about its assembly business in China, as did the
Taiwanese ODMs contracted to make Apple products.
According to reports by industry watcher
DigiTimes, Inventec and Quanta are contracted to
make video iPods, while Foxconn (owned by Hon Hai)
manufactures iPod Nanos and Asustek the iPod
Shuffle.
Taiwanese ODMs work on two basic
production models. Apple and HP buy "full systems"
from their contracted manufacturers - complete
products that can be shipped direct to the
customer or retailer. This means they in effect
outsource 100% of the manufacturing process. Wu at
iSuppli says it makes sense for Apple to order
finished iPods because, as standardized goods,
there is little point in doing final assembly
in-house. Apple's profits come not from
manufacturing but from product innovation and
design, and control of marketing and customer
relations.
The second production model
involves manufacturing "bare bones" units, which
usually include a motherboard, enclosure, cables
and connectors, but not the microprocessor,
display, keyboard, hard drive, optical drive,
memory or battery. The bare-bones laptop is then
passed on to the PC brands, notably Dell, for
final assembly and shipment to end users. This
does not diminish, however, the role played by
Compal, Quanta and Wistron, Dell's principal ODM
suppliers.
According to a recent report by
CAPS: Center for Strategic Supply Research, the
role ODMs play "in the design of the notebooks
they manufacture ... differs from one flagship to
another and between each particular bid that is
going out. Many of the flagships, such as Dell,
invest very little in R&D [research and
development] and count on their ODMs and the
component suppliers to innovate and design the
next generation of notebooks."
Dell China
spokeswoman Christina Zhu was quick to dismiss
reports that Dell has abandoned manufacturing
altogether: "When people say that Dell outsources
100%, they are wrong. Although Dell doesn't make
any of its own components, we do all our own
sourcing, and we do all the final assembly in our
own factories."
For Dell, which allows
individuals to custom-design their own computers
on a build-to-order model, it makes sense from a
quality-control point of view to assemble the
final products in its own factories. Dell
maintains an export-processing center in Xiamen
for shipping finished desktops, notebooks and
servers to customers in Northeast Asia, as well as
other final-assembly factories in Malaysia and
Ireland, to which Dell's contract manufacturers
export direct.
Deciding whether to
purchase full systems or bare-bones computers
reflects how much control the global brands want
to have over the manufacturing process. HP orders
full-system desktops but works very closely with
Hon Hai, which has its own warehouses close to the
market in the US and Europe, where it completes
final configurations.
Although more than
two-thirds of computers are now ordered as full
systems, global PC brands continue to procure key
components, which they pass on to their ODM
manufacturers, as a way of retaining some control
over the manufacturing and assembly process.
Global PC brands thus keep their ODM suppliers on
a tight enough leash to capture the larger profits
that arise from marketing and retail while
simultaneously outsourcing most of the
manufacturing and much of the R&D to squeeze
costs.
The computer industry is a perfect
example of where different countries sit in the
value chain: the US at the top, Taiwan in the
middle, mainland China at the bottom. Can the
Chinese computer industry move up the value chain?
The CAPS study is blunt about China's limitations:
"There are no Chinese ODMs and there are no
significant Chinese suppliers to the Taiwanese
ODMs, or to their suppliers."
Merrill's
Tseng also doubts whether mainland China will ever
produce a homegrown competitor to the Taiwanese
ODMs: "No, it's too late. All the major global
brands rely on Taiwanese companies and suppliers,
who control this part of the supply chain. The
market is too mature for new players to enter. The
only value added by China is the efficiency it
brings to the assembly process, not its own
technology."
The notable exception, of
course, is Lenovo. Last year's $1.75 billion
acquisition of IBM's PC unit saw Lenovo leapfrog
into the top tier of computer companies to become
the world's third-largest PC brand by volume.
Although profits since the takeover have been a
little disappointing - for the three months to
September 30, net profits declined to $38 million,
compared with $45 million a year earlier - Lenovo
was the biggest gainer of any Hong Kong blue chip
in 2005, rising 53.8% over the year to about
HK$3.70 (47.5 US cents) per share.
Lenovo's shipments grew 10.3% last year,
in line with the overall PC industry (though
slower than rivals Dell, HP and Acer). Tseng says
that Lenovo's profit margins lag slightly behind
Taiwan's Acer, the world's fourth-largest PC
maker, largely because it is still suffering from
the volatility incurred by the takeover.
There are signs that Lenovo will become a
genuine global player. Like its rivals, Lenovo
employs Taiwanese ODMs in the mainland to
manufacture its branded computers - and, in a
sense, Lenovo's acquisition of a global brand
represents an attempt to bypass the ODM stage
completely. Yet Lenovo is the exception that
proves the rule: lacking the marketing and
technological prowess of its rivals, it had to buy
what it had struggled to develop itself.
The company's headquarters have moved to
the United States, and US engineers are largely
responsible for developing new products (in
conjunction with their ODM suppliers). If Lenovo
is a global player and mainstay of China's export
economy today, it is rather a reflection of the
domestic computer industry's continuing weakness
than of any burgeoning strength.
Part 2: Working up the value
chain
Tom Miller is the
Beijing-based deputy editor of the China Economic
Quarterly.
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