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With their main business in notebook PCs under pressure, original design manufacturers (ODMs) are adding new capabilities that will allow them to capitalize on the soaring sales of ultrabooks, according to the latest IHS iSuppli EMS & ODM Market Brief report  at information and analytics provider IHS (NYSE: IHS).

Gross margins for ODMs focused on making notebook PCs have trended downward for the last four years. During the last two years alone, average margins for notebook PC ODMs have slumped from 8.15 percent in the first quarter of 2010 to 5.79 percent in the fourth quarter of 2011. The year-to-year change from 2010 to 2011 stood at a dismal 0.48 percentage points, indicating dwindling profitability in making notebook PCs, as shown in the figure below.

“Notebook PCs now represent between 70 to 90 percent of ODMs’ total revenue. However, margins for producing the mobile computers have come under increasing pressure,” said Thomas J. Dinges, CFA, senior principal analyst for EMS & ODM research at IHS. “ODMs are latching onto vertical integration as the most sensible way to reverse their declining margins in notebook PCs. Vertical integration not only will allow ODMs to keep costs down, but also will augment their capabilities, allowing them to improve their competitiveness in the fast-growing ultrabook segment.”

ODMs Get on the Case
In particular, ODMs during the past year have increased their equity investments for casing companies, dazzled by the strong business enjoyed by suppliers like Catcher Technology from China and Taiwan’s Foxconn Technology. These firms sell metal cases that serve as the frames of electronic devices.

Both Catcher and Foxconn make casings for Apple Inc., laptops such as the MacBook Air, which served as the model for the Intel Corp.-led initiative for ultrabooks, the super-thin rival computer to the Mac, and to the media tablet. “The ODMs now are hoping to jump in on the action on ultrabooks—predicted to be the next big growth sector in computing—by securing the casings for anticipated future ultrabook orders,” Dinges said. “The ODMs know that both Catcher and Foxconn are already committed to Apple and are unable to provide any more outside support, which makes it crucial for the ODMs to line up future casing sources.”

To date, Taiwanese-based Compal Electronics Inc., the No. 2-ranked ODM, has invested tens of millions of dollars in joint ventures with casing suppliers in China to support the needs of its notebook customers. Other ODMs, such as No. 1 Quanta Computer, No. 3 Wistron Corp. and No. 4 Pegatron Corp.—all based in Taiwan—have also invested considerable capital in vertical casing capabilities

Overall, the major notebook ODMs will attempt to procure up to 10,000 machines this year for their casing manufacturing operations and joint ventures. With the production of ultrabooks expected to ramp up and Apple’s sales continuing to grow, casing supplies will remain tight for the foreseeable future, IHS believes. As such, the opportunity for ODM providers to add some incremental margin—or at least to equity-investment income through their investments—should remain positive at least through the end of this year. 

Other Trends in Outsourced Manufacturing
With profitability remaining a challenge this year, outsourced manufacturers are also facing rising labor costs and a pressing need for stronger revenues.

Earlier in March, controversy erupted over alleged widespread labor violations in the workplace by Apple supplier Foxconn. The resulting investigations—which had the effect of raising labor wages and thus, costs—have alerted OEMs across the outsourced manufacturing industry to the importance of keeping their brand equity from being damaged or tainted by scandal or any untoward events.

Given the intense scrutiny from both the press and other industry watchers, a repeat of any major labor infraction is not likely to be tolerated, IHS believes. This, in essence, raises the bar for the whole electronics industry to ensure that all companies in the outsourced manufacturing supply chain comply with local laws. 

For the rest of the outsourced manufacturing business, the need to book new revenue will remain of prime importance. In particular, the financial challenges in Europe, slowing growth in China and questions surrounding the strength of the U.S. recovery could end up making 2012 similar to last year—with optimistic estimates for growth topping out in the early or first half, and then expansion proceeding to dive down to worrisome lows for the rest of the year.