OEMs Retain Firm Grip on Purchasing Power

Purchasing conditions continue to whipsaw in the electronics industry but OEMs and contractors remain on top of the food chain, benefitting from weak pricing and easy availability of supplies amidst heavy discounting by harried vendors. However, OEMs, too, are stressed with uncertain demand, the stronger dollar, a potential hike in U.S. interest rates and conflicting economic signals from China.

The picture remains fuzzy for how the future might unfold for the supply chain. Currently, though, OEMs are ascendant in the perennial power-play over component pricing and supply. Hardly any electronic parts are in short supplies. Rather, suppliers are bending over backward to satisfy the few growing OEMs – like Apple – that continue to defy the stiff economic headwind.

To keep sales up, suppliers are offering favorable pricing terms and transferring the majority of gains from lower raw material pricing to customers, according to industry observers. This trend is very pronounced in China, the world’s No. 2 global economy and a major manufacturing center for electronic devices, according to research firm Markit.

“Average cost burdens in China’s manufacturing sector fell for the 15th straight month in October,” Markit noted in a report summarizing the results of its monthly survey of manufacturers in China. “Panelists overwhelmingly linked lower input costs to reduced prices for a broad range of raw materials, with metals mentioned in particular. As part of efforts to boost customer demand, companies generally passed on their savings in the form of lower selling prices. Moreover, the pace of discounting remained solid overall.”

Although supplies are plentiful and available at favorable pricing rates for OEMs, they could face a backlash later from component vendors many of which are scaling back production, cutting inventory stocks and engaging in mergers and acquisitions (M&A) to bolster product offerings or eliminate competitors. The rate of M&A activities in the industry has picked up rapidly in the last year and it is resulting in a reduction in the number of semiconductor suppliers especially, further raising the certainty of pricing power shifting to vendors in future, according to industry analysts.

Greg Wood, Director, IHS Technology Group

“With slower growth projected for the semiconductor industry, company executives are looking more toward acquisitive growth versus organic growth in 2016,” said Greg Wood, a director at IHS Technology Group in a report. “Many semiconductor companies are also looking to improve their product portfolio by offering a more complete solution to customers with more integrated systems. Some companies look to acquisitions to create more steady revenue year around with less seasonal spikes. And finally, semiconductor companies are also looking to improve margin and/or market share by buying competitors or sell off less profitable business lines.”

The flurry of acquisitions highlights the challenges many companies face today in the electronics supply chain. The softening of China’s economy began months ago but the effects are only now beginning to percolate through the supply chain. Component vendors are slashing prices to attract and retain customers, spur new sales and keep production humming. However, the tough competitive environment has only made it easier for OEMs and purchasing managers to squeeze out further discounts from the embattled suppliers, further exacerbating their distress, according to the results of the Markit survey.

The situation has become quite obvious in China but the effects are worldwide. China’s manufacturing conditions worsened in October, for example, making OEMs and their suppliers even more cautious about the future at a time companies should be ramping production for the typically strong end-of-year and holiday seasons. The Caixin China General Manufacturing Purchasing Managers’ Index climbed in October to 48.3 from 47.2 in September but conditions have “now worsened in each of the past 8 months,” according to Markit.

“The slight upswing shows the manufacturing industry’s overall weakening has slowed down, indicating that previous stimulating measures have begun to take effect,” said He Fan, chief economist at Caixin Insight Group in a press statement. “Weak aggregate demand remained the biggest obstacle to economic growth, and the risk of deflation resulting from the continued fall in the prices of bulk commodities needs attention.”

Here are further takeaways from key segments of the latest Chinese PMI report:

Output Index: October data signaled that Chinese manufacturers lowered their production for the sixth month in a row. After adjusting for seasonality, however, the rate of reduction was the slowest seen in four months and only modest. Anecdotal evidence suggested that companies cut output in response to fewer new orders and weak market conditions.
New Orders Index: Adjusted for seasonal variance, the New Orders Index remained below the no-change 50.0 value and pointed to a further fall in total new business placed at Chinese manufacturers. That said, the rate of contraction was the slowest in the current four-month sequence and moderate overall. A number of surveyed companies commented that poor economic conditions had led clients to be more cautious towards spending in October.
New Export Orders Index: Manufacturing companies operating in China saw an increase in new work from abroad in October, thereby ending a three-month sequence of reduction. That said, the rate of expansion was only marginal. Where increased new orders from abroad were recorded, it was generally linked to improved foreign demand.
Output Price Index: Chinese manufacturing companies signaled a third successive monthly increase in stocks of post-production goods in October. After adjusting for seasonality, however, the Stocks of Finished Goods Index indicated that the rate of accumulation slowed to a fractional pace. Fewer new orders were cited as a factor leading stocks of post-production goods to increase.
Quantity of Purchases Index: Chinese goods producers continued to cut their purchasing activity in October and at a solid rate. Input buying has now fallen in each of the past four months. Firms that recorded lower purchasing activity widely attributed this to fewer new orders and a subsequent decline in production requirements.

In essence, purchasers can continue expecting favorable terms from suppliers in the near future. Falling demand has tamped down on raw material costs and suppliers have been trying to pass the additional savings to their customers in the hope of spurring end-market demand. The effects of this move won’t be known for a while.

In the meantime, component vendors are carefully managing inventories to limit the likelihood of excesses being built up at a time of weak demand. They have throttled back on production even as they offer deep discounts to purchasers to clear old stocks.

This could be a double-edged sword for the entire supply chain. A sudden and stronger-than-expected demand pickup could result in spot shortages of some components and drive up prices across the industry. Although this is unlikely at least for the immediate term, it is not impossible considering the history of the industry.

Market consolidation could also heighten the effects of a sudden upswing in demand. As companies bulk up through acquisitions, the ranks of suppliers is also thinning out for key components, potentially transferring power to survivors and exponentially increasing the leverage they may in future have in component pricing negotiations with OEMs and other buyers.

In a recent report IHS noted that the number of top revenue generators in the semiconductor industry shrunk dramatically in the last years and noted the trend will continue as M&A actions pick up in 2015. The market segments so far impacted include memory and micro-components, according to the research and consulting company, which projects the logic and analog ICs sectors could see a similar spurt in activities.

Dale Ford, VP & Chief Analyst, IHS

“Not surprisingly, the memory and microcomponent segments have reached the highest level of consolidation with the top five representing 89 percent and 85 percent of total revenues, respectively, in these markets. IHS projects that the top five Logic IC suppliers will capture 52.5 percent of revenues, an increase of nearly 23 percent in 7 years.” said Dale Ford, VP and chief analyst at IHS in a report. “The analog IC, discrete, optical and sensor markets have seen either minimal consolidation or deconsolidation. However, current discussions and trends point toward the strong possibility that the analog IC segment could be the next area to see a growth in consolidation activity.”

If the trend identified by IHS persists, purchasers will be forced to patronize a dwindling number of component vendors who will exercise greater control over supplies and pricing. Rather than pound suppliers deeper into the grounds, therefore, purchasers should use the current demand environment to deepen their relationships with top suppliers that are likely to survive the ongoing winnowing.

They will need these vendors when the demand-supply and pricing pendulums swing back in favor of suppliers as they are wont to in this industry.