How did the world's largest software publisher become a hardware manufacturer overnight? One word: Flextronics

I

The future of Microsoft is rolling off an assembly line deep in the heart of Mexico, one black plastic console at a time.

It's there that workers are building the Xbox, the gaming device scheduled to hit retail shelves nationwide November 15. Over the next 18 months, the Xbox brand will be pounded into the consumer psyche with all the brute marketing force that half a billion dollars can buy. How the game console that wants to rule your living room fares in the marketplace is sure to be an interesting tale. But the real wonder of the Xbox launch is how a software publisher that has never operated a single factory has come to challenge the world's leading manufacturer of consumer electronics - Sony - at its own game.

That story starts a few miles northwest of Guadalajara, at Parque Integral de Tecnologia, an industrial park complex owned and operated by a company called Flextronics. Without Flextronics, there would be no Xbox - only the idea of it. "Microsoft has a ton of money, but if they had to build factories, they wouldn't have done this project," says Flextronics chair and CEO Michael Marks. "If guys like us didn't exist, guys like Microsoft wouldn't do a hardware product. The risk would be too high."

The 50-year-old Marks is quick with a smile and speaks at a pace that suggests he's onto something big, namely a sector known as electronics manufacturing services, or EMS, which assembles things like PCs and consumer gadgets for clients. Since he took the top job at Flextronics in 1993, Marks has been preaching the benefits of contract manufacturing to consumer electronics companies of all stripes. Why own and operate your own factory, he argues, when you can give the dirty work to us, and save money?

It's taken a while, but the marketplace is finally listening. Flextronics has grown from $93 million in revenues in 1993 to about $15 billion this year. The company - a member of the Wired Index since June 2000 - has a market cap larger than any of its competitors and is second in revenue to longtime industry leader Solectron. The tech downturn, which forced many companies to close manufacturing plants, has been good to Flextronics et al. Marks is savoring the emergence of the EMS sector like a man who has stumbled out of a dark tunnel.

"It used to be a really crappy business," Marks says. "We used to try to convince purchasing agents how we're going to do things cheaper. Now we're talking to CEOs. We're defining global manufacturing strategy. That's fun."

Microsoft is only one of Marks' A-list clients. Operating 80 factories in 28 countries around the world, Flextronics makes cell phones for Ericsson, routers for Cisco, printers for Hewlett-Packard, and PDAs for Palm. Flex is one of 11 EMS companies that have established factories in Guadalajara to take advantage of cheaper labor and relaxed trade between the US and Mexico. "It became very obvious after Nafta that Guadalajara was the place to be," Marks says.

To see the operation firsthand, you have to travel along a pothole-riddled road that would be less bumpy if it was just plain old dirt, maneuvering past livestock, gasoline trucks, rice-and-bean stands, and the occasional local peeking from beneath a giant cowboy hat. Clear the guardhouse in front and suddenly everything changes: manicured lawns and shrubbery, flawless roads, a corporate cafeteria, and what the locals call "the best soccer field in town." With 4,800 employees, Flex's Parque Integral is a $250 million, 124-acre oasis of Silicon Valley-style opulence in a desert of poverty.

On the east end of the campus is a new two-story edifice. Inside - past another layer of security - is an astonishingly pristine white-floored assembly room filled with tens of millions of dollars' worth of machinery and hundreds of workers in heel straps and lab coats. Rolling metal doors flank the lines. Supplies come in one end; Xboxes go out the other.

At this moment, a team is working out the last-minute kinks, churning out Xbox Debug Kits for developers - similar to the Xbox, but with a translucent green case - and steeling themselves against the coming storm. "Two months ago, there was nothing in here," says business unit director Klaus Maier, "owner" of the Xbox building, as he walks between rows of SUV-sized machines with names like the SonoFlux 9500 and the Heller 1800 EXL.

Maier has the weight of Microsoft on his shoulders. Unlike Sony, which couldn't fill early demand for the PlayStation 2 because of silicon supply problems, Redmond has promised it will deliver. (Nintendo was scheduled to introduce its new console, the GameCube, to the US a few days before the Xbox launch. But the company has delayed the rollout until the end of November, leaving Microsoft first to market.) Flextronics plans to ship 800,000 units at launch and 700,000 more by year's end. To meet those goals, production crews will be cranking 24/7 at least a month before the launch date. One tractor-trailer rig full of Xboxes will have to leave the facilities every two hours, and one semi full of supplies will come in at the same pace. Maier, who has been logging 100-hour weeks since February, is looking to hire 1,000 new employees - fast.

And if he's lucky - if the Xbox does as well as predicted - he expects Microsoft will ask him to double his capacity. Then he'll have to construct another building, find more equipment, and go on another hiring binge. Maier figures he won't see a vacation day for the next year.

The good news is he has a state-of-the-art manufacturing plant at his disposal. Sixteen Flextronics suppliers and a customs clearinghouse call the campus home. Flex even makes many of the common components itself. Which means no waiting for materials, no pile-ups at the border, and no unreachable suppliers. It's a model that has competitors scrambling to catch up - and Wall Street analysts raving.

"Michael Marks is the pied piper of the EMS sector," says Matt Zolin, a vice president at Lehman Brothers.

Marks is more modest about his success. "People say, 'Oh, you're so smart,'" he says with a smirk. "And I say, 'What, because we're doing what Henry Ford did in 1927 at River Rouge?' This is not genius. It's about being in the right place at the right time, and it's about execution."

II

For EMS companies like Flextronics, it's almost as if the tech downturn never happened. In a survey of original equipment manufacturers in IT industries, 85 percent foresee increasing the amount of work they'll hand off to contract manufacturers in the coming years. The June report by Bear Stearns predicts that half of manufacturing will be outsourced by decade's end - versus 13 percent today - accounting for more than $500 billion worth of product.

How can one segment, which relies almost entirely on ailing customers, continue to grow in the face of the greatest downturn in the history of information technology? For starters, there's the now-familiar trend of moving factory work off American soil to get cheap help. For decades, US firms have found big savings by shifting manufacturing offshore. But Flextronics' relationship with its customers represents something new and more profound than simply cutting labor costs.

Given the relative complexity of their products, electronics companies have long considered manufacturing expertise a strategic aspect of business - a point of differentiation from their competitors. But that's changed in recent years. Electronics manufacturing has become a commodity. The reason, unsurprisingly, is digitization.

Not long ago, a telephone was about as closely related to a 35-mm camera as to a lawn mower. Today, your cell phone and your digital camera are cut from the same cloth. Many of the electronic gadgets in our lives, from PDAs to inkjet printers, share the same basic DNA connectors: circuit board, processor, some plastic, and sheet metal. Their value comes not in the assemblage of these parts but in the electronic brains and the brand on the outside. For the typical OEM, the act of assembling components is a distraction - diverting brainpower from innovation - and a cash drain.

PC manufacturers have known this for years. HP, for example, doesn't make any of its personal computers. The manufacturing is handled by Flextronics competitor SCI Systems. HP adds its value to the computer through design and marketing. Increasingly, electronics companies from SonicBlue to Motorola to NEC are going the same route.

Early this year, the world's second-largest cell phone company, Ericsson, handed its entire handset business off to Flextronics, from design to fulfillment. It's a deal that will mean an additional $2 billion in annual revenue for Flextronics. Similarly, Handspring's PDAs are assembled by both Flex and its competitor Solectron, leaving Handspring to put all its efforts into technology and design. From order to delivery, Handspring never handles a product. Everything's done by Solectron and other contractors. Handspring doesn't even pay for the product until 30 days after it ships.

The move toward outsourced manufacturing represents an obvious opportunity for contract manufacturers, but it's also a potential boon to product innovation. The future of gadget-making is not about making gadgets; it's about imagining them. Someone else makes the imaginary real.

"All that money that used to go to fund infrastructure is going into design and innovation," says Marks. "The companies that thought they were being competitive by having manufacturing, well, now all their factories are half full, and they're just getting cranky."

The result will be a hollowing out of the consumer electronics industry reminiscent of the forces that shaped the computer industry. Consumer electronics now is dominated by huge, vertically integrated conglomerates such as Matsushita (Panasonic), Sony, and Philips. The demands of component sourcing, manufacturing, distribution, and winning retail shelf space, all on the huge scale necessary to make money on slim margins, keep such unwieldy corporate giants on top. But take away the sourcing, manufacturing, and distribution, and suddenly the picture looks very different. All the value heads to innovation and marketing, allowing smaller companies, entrepreneurial firms, and those from outside the electronics industry to compete head-on with the incumbent titans. Microsoft is now taking on Sony, but tomorrow it could be Virgin. Or Nike. Such is the power of an enabling technology like contract manufacturing.

With Microsoft embracing the EMS model, Marks thinks the stage is set for a fundamental change in the way consumer electronics are manufactured. "This industry is going to turn out like automobiles and oil," he gushes. "We're going to have $60 billion companies. Next year is going to be an absolute blockbuster."

III

J Allard is best known as the person at Microsoft who believed in the Internet way before Bill Gates did. In the past decade, he's directed the company's TCP/IP networking strategy and helped plan Microsoft's .NET initiative. But Allard's first love is gaming, and about two years ago he was chosen to spearhead the company's digital entertainment initiative.

Allard got a new title, GM for the Xbox platform, and helped write a business plan that would have Microsoft jumping into the game console market. The goal was not simply to take on Sony and Nintendo in gaming, but to get a toehold in the more lucrative world of digital home entertainment. "What started out as something that had potential for 100,000 units turned into a console that will go to tens of millions of users and grow into a business that'll be worth billions," says Allard.

Allard and his team encouraged the game development community to think about a console that would "intimidate their imaginations." The first thing the developers wanted was more memory. Done. Then they demanded more polygons, offloading as many as possible to the graphics chip. Done. "But we said, 'Where's the revolution? You're asking us to do more of the same,'" Allard remembers. "And then they said, 'Let's complete the illusion.'"

Game developers wanted the same level of continuity found in Hollywood feature films. Allard came to believe that with a DVD player, an Ethernet port, a 733-MHz processor, and a killer graphics chip, the Xbox would be a full-feature entertainment device that could do for the home what the PC has done for the office. He'd build on the architecture of the PC so the developers would have a familiar platform on which to work, and sell the box at a low price point.

Just one problem: Who could make this thing?

"We talked to Michael Dell, and the guys at Gateway and Compaq," Allard remembers. "They said, 'Wait, you want to make 50 million of the same exact thing? That's not what I do.' Dell said, 'I don't want to be in the razor business if I can't get in on the blades. You're talking to the wrong guy.'"

It's probably a good thing for Microsoft that Dell didn't bite. PC manufacturers don't drive prices down; they drive technology up and keep prices stable. The Xbox will sell for $299 at retail - losing as much as $110 on every box sold - and Allard wants to get the retail price to $100 as quickly as possible.

Flextronics was already making Microsoft joysticks and keyboards, and Allard knew the company could squeeze costs out of the supply chain. "We had to pick a manufacturer that's an expert in driving every possible penny out of the process," he says. Allard asked Marks and his team to put in a bid. By Valentine's Day 2001, the two companies had signed a contract.

A few weeks later, Allard gathered Intel, which was supplying the processor, and Nvidia, which provided the graphics chip, to talk specifications. Flextronics was there too, consulting on the implications of each decision. "We'd say, 'Hey we want eight controller boards.' They'd say, 'Your power consumption just went up 8.8 watts, which increases form factor by 8 square centimeters and weight by 2 ounces,'" Allard recalls.

"If we hadn't chosen Flex, we never could have done this in 14 months. The PS2 was 30 months from conception to delivery."

It may seem like a risky proposition for Flex to have to put so much effort, money (as much as $50 million, says Marks), and personnel into a project on such a high ramp. Even a flawlessly manufactured Xbox may not outsell competing consoles. But Marks never hesitated. "Once we have a customer, we want all of their projects," he says.

"This is a complicated assignment because there's a lot of technology involved and because you have a Christmas window. But I wouldn't say it's more complicated than launching a next-generation optical network."

In the trenches, though, things got muddy fast. "There were a gazillion things to think of, from what equipment we'd need, to how many people to hire, to how many screwdrivers we'd be using," says Flextronics SVP Jim Sacherman. "If you wait until the product is being designed to work out those kinds of details, it's way too late."

The company built operations in Guadalajara - to feed North America - and Hungary, to fill European demand. It began talking with suppliers, working out shipment schedules with Intel, Nvidia, Western Digital (hard drives), and Micron (memory), as well as with materials suppliers for plastic parts and screws. Once the prototypes became available, Flex began testing - thermal testing, design validation testing, and process validation testing - to make sure every component is doing what it's supposed to be doing. Not only would the tech need to hum, but the Xbox would need approval from the FCC to ensure that the assemblage wasn't leaking radio waves. And then there was the sheer volume to consider.

"It's really easy to make one thing work right," Sacherman says. "It's hard to make a million things work - all of them, all the time."

IV

Incorporated in Singapore with its management offices in San Jose, Flextronics has factories worldwide. Its industrial parks, which house suppliers onsite, are concentrated in Brazil, China, Hungary, and Mexico. Workers earn from 70 cents per hour in China to $4.50 in Brazil. (Maier's Xbox employees make between $3 and $4 per hour.) By manufacturing in low-cost regions, Flex can cut 75 percent of the price of labor. Still, the company offers more than reduced labor costs.

Sacherman gives an example of a typical product that would run an original equipment manufacturer $100 to build - say, an HP printer. The numbers vary, but in general the biggest expense, by far, comes from the materials. Including transportation of supplies to the manufacturing site, materials would total $76. On top of that, the OEM would face $8 in overhead (for maintaining a factory and equipment), $4 in freight (delivery to the retailer), $6 in sales, general, and administration costs, $4 in labor, and $2 in finance (expenses associated with maintaining an inventory). Flex can cut in half the combined costs of finance, SGA, and overhead, thanks to having many clients, managing operations on one ERP system, running factories to 90 percent efficiency, and allocating common supplies, like circuit boards and plastics, across its customer base.

Where Flextronics really shines, however, is in that cost of materials. By making many components onsite, and housing suppliers onsite, Flex keeps delivery times and expenses to a minimum. The company works with clients on product design to decrease the number of parts - and thus the manufacturing expense. Finally, the $12 billion in supplies it buys annually gives Flex considerable purchasing power. Add it up, and Flex strips $8 out of the seemingly fixed $76 cost of materials. Tack on a 4 percent profit, and the original $100 has become $84 in total OEM costs. "For a company that was making 20 points of profit, selling it for $120," Sacherman says, "they're now making 35 points."

High tech gadget sellers love those kinds of numbers. "The value we bring to the market is in the design, development, and marketing of handheld computers. It's not in manufacturing," says Handspring VP of worldwide manufacturing Mike Gallucci. "The margins that Solectron or Flextronics are taking are razor thin, so they have to be much more efficient."

The folks at SonicBlue, "makers" of all kinds of products, from ReplayTV and Rio to DVD players, use several contractors. "Our focus is on creating unique technologies - 100 percent of our manufacturing is done by other people," says COO and CFO John Todd. "If you don't have to tie up our cash and assets and people, it enables us to be creative."

V

For all of its success, Flextronics, with 11 percent market share, trails EMS industry leader Solectron, which has 17 percent. Based in Milpitas, California, Solectron has become big partly through acquisitions, most recently swallowing Canada's C-MAC and Iphotonics as wedges into automotive electronics and optical manufacturing. And the fast-growing Celestica - formerly the Canadian manufacturing arm of IBM - is nipping at Flex's heels.

Flex is playing the acquisition game itself. Over the past several years, it has snapped up several companies, including Palo Alto Products - which made Palm PDAs - and Telecom Global Solutions. With Flextronics' relatively stable market cap and more than $600 million in the bank, the company may well be tempted to do more shopping.

But Marks doesn't want to chase anyone. Even at Flex's current growth rates, which it should be able to maintain by increasing the percentage of business it's getting from existing customers, the company will have $46 billion in revenue by 2006. Anything beyond that might be uncontrollable. "There's no doubt that there's a demand for our services out there," he says. "Companies come to us because we're quicker than they are. We have to be careful not to get so big and slow that our model falls apart."

Flextronics is in better shape than rival EMS companies because it draws clients from a wide range of business sectors. Ericsson now accounts for 13 percent of Flex's overall revenue, but no other customer accounts for more than 10 percent. By contrast, 70 percent of competitor Sanmina's business is in telecom, making it more vulnerable in downtimes.

Even as Flex looks to win new business, there's growth to be found in its existing client base. Siemens and Philips, both significant Flex customers, still do much of their manufacturing in-house. There are also opportunities in Eastern Europe, where Flextronics has the biggest presence of any EMS. The Japanese market for consumer electronics is expected to grow to $253 billion by 2003 - representing more than a quarter of the worldwide total. According to Bear Stearns, three-quarters of Japanese OEMs plan to do more outsourcing in the next year. Flex is already working with Toshiba and Epson, and may one day soon land Sony, which has pledged to reduce the number of company-owned factories by the end of 2002.

And then there's Microsoft. Snagging Redmond as a client is vital, if for no other reason than it's not in the telecom biz. "The Xbox is an important contract," says Todd Coupland, an analyst with CIBC World Markets who covers the EMS industry and rates Flex as a strong buy. "A lot more so if it's successful."

With the gaming world more competitive than ever, companies spend a lot of money to get products into the hands of consumers. All of which makes Microsoft's $500 million marketing budget the key figure in this game of numbers. John O'Rourke, director of Xbox sales and marketing, says that the launch will be as big as the rollout of Windows 95. But this time, the message will have a different feel. With the help of ad agency McCann Erickson, which is developing TV spots, plus in-store displays and "mobile gaming raves," Microsoft will be cast in the unlikely role of underdog. "Sony has a brand that is today's videogame standard," he says. "We won't be saying, 'This is Microsoft,' we'll be saying, 'This is Xbox, and we're shattering the perceptions of what the next great game experience can be.'"

In late September, Microsoft announced it was delaying launch by a week, to November 15, due to what it said were supply problems related to the World Trade Center disaster. The pressure is on Flex to hit this new schedule. If O'Rourke overspends based on demand calculations - instead of what's actually coming off the lines in Mexico and Hungary - he's wasting his money. And worse, he'd be driving consumers into stores where they might not find an Xbox, but they could pick up a PS2 or GameCube instead. Retailers announced in early September that they had sold out of Xbox pre-order bundles - at $499 each. As far as Xbox GM Allard is concerned, Flex can't make too many machines before Christmas.

Whether Microsoft can actually sell 50 million Xboxes over the long term, as Allard says they will, comes down to the games themselves. For Michael Marks, Microsoft is an important client that he'll happily service as long as it keeps his factories full. But if orders start to lag, there are plenty of tech companies out there waiting to use his assembly lines.

"More and more companies are going to outsource - we're just going to get a lot bigger." Marks smiles: "We're running out of countries to go to."

As the growth of the entire EMS sector continues, the old ways of manufacturing will increasingly be consigned to history. Deep in the heart of Mexico, the Flextronics assembly lines are shaping not only the future of Microsoft, but the future of all things electronic.

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