* Many companies struggle with razor-thin margins
* Diversification into high-value business key to growth
* Rising input costs, wages threaten sector
By James Pomfret and Clare Jim
HONG KONG/TAIPEI, July 28 (Reuters) - Contract manufacturers rolling out an array of gadgets such as Apple's iPad, Dell's PCs and other devices in China are re-examining their business models as they grapple with surging costs and shrinking margins.
Companies including contract PC notebook maker Taiwan's Compal are diversifying into software development, coming up with their own products or positioning themselves as high-tech firms rather than simple low-margin factory operators for other brands.
Many are looking at the success of Taiwan's HTC , which over a five-year span has evolved from a contract maker of other people's phones into one of the world's biggest smartphone makers. Despite being perched relatively high in the technological foodchain, electronics contract makers in China have fared little better than low margin makers of shoes or clothing.
"We'll have to move up the ladder and come up with more innovative products to lift margins and selling prices," Ray Chen, president of Compal, the world's second largest contract laptop maker that has factories in China, said last month . "We have to do it, there is no choice." Compal is expanding its software team and is also investing in research and development and software design and tablets.
In China itself, surging blue collar wages and production costs, along with the inability of many firms to wrest higher prices from hard-bargaining global clients, has led to razor-thin margins, which some companies cannot survive on for long.
After a 30 percent rise last year, growth in the global outsourced manufacturing industry is expected to slow to 11-12 percent this year on anaemic Western demand, surging wages and rising prices for base metals such as copper, research firm IHS iSuppli said in a note.
INDUSTRY WOES "The costs have increased a lot in all aspects, not only on the materials side but on the labour and also the exchange rate," said Leon Zong, a China manager of Amphenol , a Nasdaq-listed maker of electronic and fibre optics connectors.
"None of these factors are good for manufacturing in China," said Zong, manager of Amphenol's factory in the southern Chinese city of Guangzhou, where hundreds of young, nimble-fingered workers weave reams of coloured cables into advanced connectors for clients such as Cisco Systems .
Even Taiwan's Hon Hai Precision Industry , the world's largest electronics contract manufacturer with around a third of the global market, has struggled. As Apple's major supplier in China, Hon Hai has seen its operating margins narrow to 2.9 percent in 2010 from 5.4 percent in 2005. Hon Hai was forced to hike wages sharply last year after a spate of worker suicides that critics blamed on a harsh sweatshop culture . An explosion at one of its factories in southwestern China earlier this year killed three workers. Some contract makers such as Foxconn have relocated some of their plants to cheaper inland cities such as Chengdu. Foxconn has also begun looking at setting up factories in other emerging markets such as Brazil to broaden its global footprint. Some smaller players are thinking of quitting the business. Mike McNamara, CEO of Flextronics , a rival of Hon Hai, recently said it was considering exiting the laptop computer business given less than ideal profit margins. INNOVATION DRIVE Though contract manufacturing will never fade away as a business, for many players the ultimate solution to the problem of shrinking margins lies in innovation.
"They need to make sure what they need to develop as an international brand. They need the ability to innovate, to go globalized and very committed on quality," said HTC CEO Peter Chou.
But analysts say only the relatively bigger players such as Quanta , Wistron , Hon Hai and Compal will have the resources to beef up their R&D capabilities.
The capability of making value-added products is also needed by PC makers amid formidable competition from Apple, said Wanli Wang, downstream technology analyst with RBS in Taipei. "You hope your contract makers can provide you something value-added, something innovative, something with different design," he said.
"Price cuts are not sustainable. Apple does not cut prices. You must be innovative to compete with Apple."
Quanta chairman Barry Lam said last month the company will enhance its R&D capability and cut production costs.
"We will have new application s and link the whole notebook business to cloud computing. The industry has to upgrade itself to an advanced/high-end industry in order to sustain growth."
Hon Hai's billionaire boss Terry Gou recently said the trend of thinning margins was becoming so acute that remoulding Hon Hai into a higher technology firm was needed, but he gave few specifics and ruled out launching his own brand.
"We are a high tech manufacturer, not a contract maker," he said. (Additional reporting by Argin Chang in TAIPEI; Editing by Charlie Zhu and Anshuman Daga)