The Case for Onshoring
September 20 2010 by William J. Holstein
When Intel Chief Executive Paul Otellini announced in February that his company would lead a group of venture capital firms in investing $3.5 billion in smaller American technology companies over the next two years, he billed it as a step to build American competitiveness. The coalition was called the “Invest in America Alliance” and his speech was entitled “Reinventing America’s Economic Future.”
But there was more to Intel’s strategy than altruism. The semiconductor giant appears to be in the vanguard of a movement by leading American CEOs in recognizing that corporate America’s offshoring and outsourcing trends, and the enthusiastic pursuit of emerging markets, have given short shrift to the technology base that supports their companies.
That’s where pure self-interest enters the picture. Intel Capital, the company’s venture capital arm, will be scouring the U.S. for investments that help the company achieve clear goals, such as maintaining the pace of upgrading its manufacturing systems every two years. These investments will, in part, go to companies in the technology clusters that support Intel’s plants in California, Oregon, New Mexico and Arizona.
Those companies’ activity “has to be very closely located to our leading edge fabrication facilities,” says Intel Capital Vice President Keith Larson. “There’s where all the R&D takes place. That’s the real locus of people doing the innovation.” If investments by Intel and the 24 venture capital firms build confidence in these companies, others will come along for the ride. “It builds on itself,” says Larson.
Intel Capital has invested $9.5 billion around the world since it was created in the 1990s, so the $200 million it is putting up as part of the Invest in America Alliance is a relatively modest sum. The two dozen venture capital firms have pledged the balance of the $3.5 billion, so Intel’s money will enjoy a measure of leverage. One example of how Intel Capital’s investments are decidedly in its interest: In 2005, it invested in Crossing Automation, a small firm in Fremont, Calif., that makes specialized tools for the semiconductor and related industries. When Intel supplier Asyst Technologies got into trouble in 2009, Intel Capital guided Crossing Automation into buying Asyst, saving 100 jobs and safeguarding Intel’s domestic supply chain.
America’s largest companies have been rushing offshore for many years and international sales now account for 60, 70 or even 80 percent of their total sales. For many CEOs of these large companies, it’s been almost an article of faith to go offshore to take advantage of more rapid economic growth in China, India and Brazil. Often, their companies receive tax incentives to locate in these countries, which also offer little environmental opposition and rare class-action lawsuits. Companies like Apple, Dell, and Hewlett-Packard have long supply chains extending around the world and manufacture relatively little on U.S. soil.
But recent moves suggest companies are rethinking that strategy. For example, NCR decided to “backshore” the manufacturing of its high-end ATMs, meaning that it brought the production from China to a former battery plant in Columbus, Ga. (See sidebar, p. 53.) In fact, signs suggest CEOs should give greater consideration to “onshoring,” meaning never moving some critical functions offshore in the first place. Instead, they should deepen their investment in clusters that state and local regions have already created, or are willing to create. Three megatrends are forcing this re-evaluation and rebalancing in strategy:
1. China is no longer the cheap play it once was.
Its announcement that it will gradually allow the value of its currency to appreciate is just the latest indication. The highly publicized strikes against Honda, which resulted in a big pay increase for Chinese workers, and the scandals surrounding suicides among young workers for Taiwan’s FoxConn, also called Hon Hai Precision Industry, have resulted in major pay increases for those workers. Some analysts say the rise of this union activity is a challenge to the central government, but that isn’t necessarily so. The government wants to move the country out of the position of being the world’s cheap labor manufacturing platform. In some respects, it may be pleased that Chinese workers are beginning to make more money.
The Chinese want to become a technology-based superpower and sense that this may be their time, in view of the financial and economic upheaval in the Western world. After 30 years of allowing foreigners to come into their country to make goods for the rest of the world, extracting solid profits along the way, the Chinese leadership is starting to restructure the economy. It is undertaking a conscious strategy to squeeze technology from foreigners by demanding more transfer of intellectual property and requiring foreign companies to carry out more research in China. It has begun to tilt its governmental purchasing policies toward domestic companies because it wants to encourage “indigenous innovation.”
With costs increasing in China and the operating environment toughening, the overall difference in the cost and risks of manufacturing there rather than here has decreased. It still makes sense to make things in China for the Chinese and regional markets. But for makers of sophisticated products for the American market, where products must meet quality standards or regulatory approval or respond to rapid changes in market conditions, the equation has fundamentally changed.
2. As a corollary, long supply chains are proving themselves too extended and too slow, particularly when middlemen, or contract manufacturers, are involved.
These outsourced supply chains also can prove embarrassing because a U.S. company does not control the conditions in which workers make their products. If Apple executives were not embarrassed by the Fox- Conn suicides, they should have been.
Add to that the shocking news that Dell sold millions of desktop personal computers riddled with faulty electrical components provided by a Japanese supplier, Nichicon, to Dell’s Asian assembly plants. Dell’s internal documents showed that it shipped 11.8 million computers from May 2003 to July 2005 that were at risk of failing because of these faulty components. If Dell—which still insists that it’s an industry wide problem— had had a firmer grip on its suppliers, this embarrassing problem— the subject of a three-year-old lawsuit whose allegations have just been made public—might never have occurred.
3. Increasing evidence suggests that placing manufacturing offshore and in the hands of outsourcers threatens to disrupt the process of innovation, as NCR discovered.
Where are the truly disruptive ideas coming from? Many, if not most, are still coming from the U.S. To avoid missing innovation born in America, companies need to make deep commitments to the clusters where relevant ideas are nurtured, or to invent their own ecosystems of innovation and production.
They need deep partnerships in those clusters to invest in, nurture and mentor smaller companies so that they can harvest the best ideas. And they need to maintain the feedback loops among U.S. customers as well as the internal constituencies involved in innovating, such as engineering, software, design and customer service. Real knowledge is contained in these ecosystems and it can be lost if the wrong functions are shipped offshore.
This suggests that CEOs should maintain their fascination with emerging markets, while recognizing that they need to be solidly grounded at home. “It would be insane to not be looking for growth outside the U.S., because 5.5 billion people in the world don’t have access to contemporary health care,” says Garry Neil, a physician who is Johnson & Johnson’s corporate vice president for science and technology. “A lot of the innovation in health care is of necessity going to have to come from there, too,” he adds. “But if you’re not in the U.S. doing innovation, you can’t expect to succeed. We’re trying to do both, but clearly our anchor is in the U.S.” If a pharmaceutical company is not deeply immersed in San Diego, San Francisco or Boston, it risks losing out on game changing ideas. “If you’re not in these places,” says Dr. Neil, “you’re missing it.” (See sidebar.)
That may be doubly true if a new, more powerful R&D model is born, as some experts advocate. Duane Roth, CEO of CONNECT, a San Diego based biotech development organization, is one of the people promoting a vision of “distributed partnering.” Roth experienced the frustration of pushing new ideas through the R&D research pipeline while at Johnson & Johnson and also the frustration of attempting to build a biotech company, only to see it fail at the last moment because of a demand from the Food and Drug Administration for more clinical trials.
For several decades, companies have had to struggle much as Roth did to build a company. They all have to go through a fairly similar learning curve. Only a tiny percentage become self-sustaining; most end up selling themselves to larger companies. “It was never about becoming a Merck— it was building something that Merck would want to own,” Roth explains. Major pharmaceutical companies, meanwhile, want the ideas that young companies are producing but don’t want to have to pay a premium to buy the companies with their bricks and mortar and their staffs.
In an article for the Ewing Marion Kauffman Foundation entitled “The Distributed Partnering Model for Drug Discovery and Development,” Roth and co-author Pedro Cuatrecasas argue that product definition companies (PDCs) should be created with small teams of professionals with deep experience in research, clinical trials and marketing. These PDCs would work with a portfolio of early-stage ideas. Rather than forcing a professor or graduate student to grapple with how to create a business, the scientist would allow the PDC to raise the capital and take the risks. PDCs might spend $2 million to $10 million to prove that a new drug is “relevant” to larger biotech or pharmaceutical companies. That’s much less than the $50 million to $100 million it can cost to establish a new idea, including winning FDA approval.
The inventors would receive up front fees, royalties and equity ownership, but they would not spend time on learning and relearning how to develop the ideas in a commercial entity. They would not have to build expensive infrastructures to support each idea. Research would be compartmentalized, in Roth’s terminology. “This model focuses on advancing ‘products’ as opposed to ‘companies,’” he wrote.
Although his comments are directed at biotech and pharmaceuticals, Roth argues that the model can be applied to information technology, environmental technologies and other fields. “If we do this, nobody else in the world can touch us,” he argues. It’s too early to tell whether his vision of a new, more rational innovation model can be achieved, but certainly the conditions in America’s technology clusters are ripe for it.
Innovation at Intel
The way Intel looks at onshoring and cluster-based innovation is instructive. Larson, a former venture capitalist, manages Intel Capital’s investments in companies that support Intel’s manufacturing efforts, including software. In addition, he has geographic responsibility for Intel Capital’s investments in South Korea, Taiwan and Latin America.
Intel says that 75 percent of its manufacturing is located in the U.S., but that 80 percent of its sales are outside the country. Its every international move is watched by critics who allege that Intel is “selling out America,” but Larson obviously differs. “We have to have a balance,” he argues. “There are going to be some things you put in different geographies. There are markets you want to address and sometimes it’s better to have a local presence.”
It appears that Intel has resisted the impulse to shift the heart of its manufacturing process outside the U.S. It has onshored. “Sometimes it’s deceptive to think that the costs are always lower overseas,” says Larson. “The semiconductor business is not, relatively speaking, highly labor-intensive manufacturing. It’s a very capital intensive business. We’re more sensitive to locating in places that have the right infrastructure support and the right financial incentives and taxes.”
Larson thinks that some CEOs are too quick to chase cheap offshore labor. “What happens is that people often don’t do a thoughtful evaluation of why it makes sense to invest overseas versus the U.S.,” he says. “A lot of times, there is a very quick judgment.”
Intel worries about investing in so many places that its activities becomes too dispersed. “We’re very conscious that we don’t want to get stretched too thin in too many sites,” says Larson. “It gets very unwieldy and any benefits you get through lower costs, you end up erasing a lot of those benefits because of the complexity.”
So even though 80 percent of Intel’s sales are from outside the U.S., it maintains a deep engagement with its home country. Some 80 percent of its R&D spending, for example, is here, the mirror image of where its sales are. “When you look at the U.S., a reason to invest in the U.S. despite all the stuff you read, is that we have the best system in the world in terms of an efficient, transparent and fair market,” Larson argues. “That’s really important. Our country risk is a lot lower. We have laws and principles that allow investors and stakeholders and management to be able to succeed.”
Heeding that lesson, American CEOs should start applying a new analytical framework as they consider where in the world to invest. Whatever precise model of innovation prevails here, U.S. clusters are going to become increasingly important in a world in which the most innovative companies win and all the others lose.
It continues to make sense to expand in emerging markets and it continues to make sense to manufacture in many of those markets to serve those customers. Some R&D there may be necessary. But a company risks losing the soul of its innovative capability if it is too dispersed and unfocused. And to serve its leading- edge U.S. customers—where competitive advantage resides—it is best to manufacture the most advanced products in a place that allows it to maintain the feedback loops among internal and external constituencies.
That implies a rebalancing of strategy, a rethinking of the impulse to offshore and outsource at the drop of a hat and to rely on supply chains reaching around the world. When local, regional and state clusters function well in the U.S., they are very powerful. As competition from China and India intensifies today, it’s increasingly clear that companies not supported by a home national ecosystem are at a distinct disadvantage against competitors that are backed by friendly governments, banks, university systems and sovereign wealth funds. As Intel has found, being fully invested in America’s innovation machine can be in a company’s raw self-interest.