(FORTUNE Magazine) – Ah! Guadalajara! !Tequila! !Mariachis! !Electronica! ?Electronica? Computers? PDAs? Cell phones? Yep. Guadalajara still gets busloads of tourists and, clustering along the shores of nearby Lake Chapala, thousands of American retirees. But this is now high-tech Mexico, hyperbolically if inevitably tagged by locals as another Silicon Valley. It's no entrepreneurial incubator like the California original. But spotted through the city and environs that sprawl into surrounding areas of the state of Jalisco are some 140 electronics companies: a bevy of brand names including IBM, Hewlett-Packard, and Siemens; the world's biggest concentration of electronic contract manufacturers; and buzzing about all of them, a few Mexican and many foreign-owned makers and marketers of electronic parts.

Guadalajara is Mexico's second-largest city, with a metropolitan population variously estimated at less than four million and more than six million. Last year an estimated $14 billion worth of electronic materials and equipment was produced in the region. A tad of that was sold in Mexico and points south, but most was hauled north to the U.S. market. Unlike the busy-fingers and sometimes environmentally squalid operations just below the U.S. border, Guadalajara's electronics plants are as bright, shining, and sophisticated as those in Charlotte, Milpitas, or Huntsville. Your Palm V, Handspring, or Mitsubishi cell phone was likely made in Guadalajara. Your IBM laptop almost certainly was. The new Microsoft X-Box, the videogame player your kid is pestering you to buy, is being built there.

The Sept. 11 terrorist attack in the U.S. had no direct impact on the Jalisco companies other than to delay shipping at the border for a few days. But their output of electronic tools and toys has sagged badly this year, just as it has everywhere else. After doubling through the mid-'90s, employment in the area's telecommunications and electronics industry reached a record high last fall, with as many as 100,000 workers. Now at least 15,000, possibly more, have been laid off. Solectron, the world's biggest electronics contract manufacturer, has cut its Guadalajara payroll from 10,500 to about 7,000. Many of those let go were temps, but most companies have also been reluctantly paring the ranks of expensively trained regulars who receive at least three months' severance pay.

Nevertheless, optimism survives. Jalisco-based contract manufacturers whose fiscal years end in the middle of the year can even say that 2001 was better than 2000. Fiscal year 2001 sales for the Guadalajara plants of SCI Systems were some $2 billion, up about 30%. But Charles Park, SCI's Latin America executive vice president, admits that expectations back at headquarters in Huntsville, Ala., were once a lot higher. His counterpart at competitor Solectron, Alejandro Gomez Montoy, tells the same story. Sales in 2001 at his Guadalajara plants were 20% to 25% higher than for the prior year, but "we were used to 300% to 400%."

When worldwide electronics manufacturing gets back on track Guadalajara will recover too. But its manufacturers will have to change, mainly by moving up the technology chain. In what symbolizes a problem faced by Mexico as a whole, Hewlett-Packard no longer builds its line of home- and small-office inkjet printers in Jalisco. Starting in 1999, production was transferred to contract manufacturers in Asia in panting pursuit of still-lower labor costs.

In the mid-'90s, Mexican wages weren't much higher than Asia's, with any difference easily offset by transpacific freight costs. Today workers on the Guadalajara plant floors are better paid than people working at plants owned by the same manufacturers in Asia or Eastern Europe. Electronics manufacturing workers in Jalisco earn $1.10 to $1.40 an hour, plus fringes that can double the cost to employers.

Mexico will always have one advantage in the global competition to make stuff for U.S. buyers. Asia and Eastern Europe are on the far side of oceans. Hecho en Mexico products aren't seaborne for a month while technology changes. But as Mexican labor costs rise, the edge provided by low-cost freight will be dulled. Mexican firms will have to offset higher wages and benefits with brains, ingenuity, and productivity. That's starting to happen in Guadalajara. Pemstar, a medium-sized contract manufacturer based in San Jose, makes zillions of Motorola cell phone circuitboards in its plant in northern China. In Guadalajara, it builds the heart of a sophisticated receiver-transmitter for fiber-optic networks. The device has more value added and hence more room for better pay.

HP has also kept sophisticated production--high-end office printers--in Mexico. It even provides a glimmer of a role for Mexicans beyond manufacturing. The company's local facility has worldwide responsibility for the design of the paper-handling parts of the company's laser printers as well as for the software that allows users to choose between paper drawers and to dictate how the output is collated and stapled.

Some of this work is being outsourced to a gaggle of young, baseball-capped Mexican engineers, male and female alike, whose consulting firm, ASCI, has festooned a downtown Guadalajara mansion with cabling and computers. ASCI was started in 1993 by Sergio Fernandez, 42, who got his engineering Ph.D. at New York's City College. Today it has 44 employees, 27 of them engineers, including some who spend so much time at HP's laser printer headquarters in Boise that Fernandez leased an apartment for them.

With a few years' experience, ASCI's engineers earn about as much as they would in the U.S., at least outside the Bay Area. That's also true for experienced manufacturing managers in Jalisco's electronics production plants. But there's the rub. Mexico needs good jobs for its educated men and women. But to pull its people out of poverty, it also has to attract and keep manufacturing plants with large payrolls.

Luring big foreign manufacturers is nothing new to Guadalajara. Siemens, the earliest, put up a plant in 1963. Kodak followed with a film plant in 1969. Today it has about 3,900 employees and a multi-building 97-acre site. The company packages film and builds all the single-use Kodaks sold in North America other than those made in Rochester, N.Y., its home base.

By the early 1980s, Kodak and Siemens had been joined in Jalisco by other global walkabouts, including AT&T, Burroughs, Hewlett-Packard, IBM, and Motorola (which recently sold its plant to On Semiconductor). These early arrivals came looking for a piece of the local market, effectively forced to locate inside Mexico by government import restrictions. The good intention of the rules was to build Mexico's industrial base. The inevitable consequence was that both domestic and foreign-owned manufacturing companies were low-volume, inefficient producers.

Later in the '80s, more-rational government policies made Mexico increasingly attractive as a low-labor-cost base. From 1989 to 1991, foreign investment in the country, largely from the U.S., quadrupled. It was stimulated greatly by the maquiladora program, under which parts can be imported from the U.S. and returned there as finished products with no duties paid in Mexico, and with U.S. duty charged only on the value added. Originally limited to the border area, the maquiladora benefits were eventually extended to other parts of Mexico. But most newcomers stayed just south of the Rio Grande and pulled unskilled workers north from other parts of the country.

Hanging on to such workers can be a problem. After brief stops, some employees keep going, slipping past U.S. immigration officials. Others save up a little money and go home. Last year, worker turnover in maquiladora plants along the border was more than 10% and even higher in Tijuana, where living conditions can be tough and California tempting. The value of electronics production on the border is roughly twice the output of the Jalisco companies. But most of it is semiskilled assembly work that can be easily moved across an ocean if wages rise enough to offset the cost of freight and of having more inventory in transit.

In 1994 two events caught the attention of U.S. manufacturers of all types that need a more stable and better educated work force. One was the start of the North American Free Trade Association, which is leading to nearly unrestricted, duty-free trade between Mexico, the U.S., and Canada. The other was the 1994 meltdown of the Mexican economy, when a sharp devaluation of the peso pushed labor costs even lower in dollar terms.

As that happened, U.S. and other non-Mexican companies coveting the American market got serious about scouting locations deeper in the country. The electronics and telecommunications firms quickly spotted Guadalajara and that original group of big names. How better for a relocation team to answer a skeptical board member than to say, "IBM has been there for years"? Or to note that annual worker turnover in Jalisco is less than 5%?

Guadalajara is more than 600 miles south of Laredo, the closest border crossing, so it takes goods produced there longer to get to market. But the compensations are many. The infrastructure is good and getting better. The highways are bearable. Manzanillo, a Pacific port through which supplies can be brought from Asia, is less than 200 miles away. There's nonstop air service to major U.S. cities.

No lower than second on everybody's list of reasons for locating in Jalisco is its collection of good universities. From them come well-trained engineers willing to start for as little as $1,000 a month, as well as young men and women with business degrees who'll settle for less. Besides the public University of Guadalajara, there's a local campus of Monterrey's Instituto Technologico and a branch of Mexico City's Universidad Panamericana and IPADE, its well-regarded graduate business school.

Not the least of the city's attractions is decent weather nearly year-round, good restaurants, cybercafes, multiscreen movie houses, and a half-dozen golf courses. Department stores are stuffed with goods, though prosperity still has lots of room to trickle down in Jalisco. Few city intersections are without flower or fruit vendors weaving between the cars, or windshield washers hustling a peso. But unlike other cities where prosperity and poverty elbow each other, Guadalajara is safe for visitors and resident managers who use a little prudence.

Freed from the protectionist straitjacket, foreign-owned plants throughout Mexico have increasingly become cogs in corporate manufacturing programs--high-volume specialists rather than low-volume, multiproduct producers. Kodak de Mexico, for example, used to turn plastic into photographic film by sensitizing, or coating, it. Now Rochester does the sensitizing for all the Western Hemisphere. Mexico just cuts the film to size and packages it. The unit's major role is building those single-use cameras in a huge plant that is partway up manufacturing's evolutionary path. Much of the work is done on heavily manned assembly lines. But these are bracketed on the front end by a battery of plastic-injection-molding equipment run by a few technicians and on the back by highly automated testing and packing machines.

Tied into a web of multinational manufacturing strategies, Guadalajara vibrates when strings are plucked elsewhere. Compaq as well as HP has moved production to contractors in Asia. NEC, which started up in the city in 1989 and most recently employed some 1,000 people making cell phones and pagers, dropped those product lines and closed its Mexican plant early this year. Lucent sold its plant to Hong Kong's VTech, which shut it down and moved production to China.

Some of the losses read like "the ankle bone's connected to the leg bone." Burroughs became Unisys, which left the Guadalajara plant to local partners, which converted to contract manufacturing and sold the operation to Singapore's NatSteel Electronics, which was acquired last year by Solectron, which didn't need two plants in Guadalajara, so it closed the acquired one and fired 1,800 people.

Of the original group of big names, only IBM keeps expanding in Jalisco. Last year, when employment peaked at some 10,000 workers--it's now down about 20%--the company built more than two million PCs and ThinkPad laptops. IBM also attracted the first of the big contract manufacturers to Guadalajara.

In 1987 IBM made SCI Systems an offer it couldn't refuse. Its executives proposed that the contractor put up a Mexican plant to build printed circuitboards, recalls SCI's Charles Parks, "anyplace in the country so long as they could see it from their front door." By the mid-'90s, much of SCI's business was coming not from neighbors in Mexico but from firms in the U.S. Today, Dell Computer, for which the Jalisco factory builds motherboards, is one of its biggest customers.

The shift in SCI's Guadalajara business from local to global reflects a worldwide trend in electronics as brand-name companies, formerly known as "original equipment manufacturers," or OEMs, cut back on manufacturing and focus more on design and marketing. A recent survey of 105 electronic OEMs by the Bear Stearns investment firm found that as a group they plan to outsource more than 70% of their manufacturing. The ECMs' plants in Guadalajara seem to be benefiting even more from this trend than their U.S. operations. Products made in the U.S. last year, because capacity was tight or because margins were high enough to cover some extra labor cost, are being moved south.

For nearly a decade SCI, which is about to merge into another contractor, Sanmina of San Jose, was Guadalajara's only big ECM. No longer. All but one of the world's largest are there, as are a clutch of small contractors and medium-sized ones like Pemstar. Since 1996, SCI has put up a second plant. Flextronics, Jabil Circuits, and Solectron have all built sizable facilities. These four have invested over $600 million in Jalisco in the past five years and probably account for at least half of the state's electronics industry's revenues. All of the ECMs build for U.S. customers for which Mexico is a first choice among low-labor-cost locations. Not only are deliveries faster than from Asia, but in addition, customers' engineers don't spend days on airplanes commuting over the Pacific.

The ECMs have grown in Mexico and elsewhere because they can do it cheaper. That's partly because they can keep plants full; when one customer's products are down, another's are up. But it's also because they live on less; margins are usually in the range of a few percentage points and thus easily squeezed by any cost increases. Nevertheless, says Steve Petracca, a Pemstar executive vice president, "this is not your mother's sweatshop." Contract manufacturers offer benefits not often found in Mexican companies: onsite banks and medical facilities, educational reimbursement plans, and bus fleets big enough to serve a medium-sized town. Such benefits have brought new people into the work force, especially young women from neighboring small villages, whose parents traditionally guarded them at home until they married.

Anxious to look as well as to be parsimonious, contractors are usually loath to spend money on appearances. But some of the new Mexican plants have a design flair not seen at the parent's headquarters. Solectron's home base in Milpitas, Calif., is an uninspired row of white boxes with a main visitor reception area that would embarrass a small tool and die shop. Solectron Mexico, erected on what a few years ago was a peanut farm, is elegant, with curves, arches, and accenting lines of color.

No manufacturing facility in greater Guadalajara is more dramatic in concept and execution than Flextronics' still-expanding 125-acre industrial park in the western suburbs. Opened in 1997, the park contains Flextronics' own manufacturing plants and is home to independent suppliers of parts, manufacturing equipment, and services for which Flextronics is not necessarily the most important customer. A company-owned plastic molding plant in the park sells more to Solectron, miles away across the city, than it does to its sister plants across the street. For tenants, entry into Mexico is eased, and startup and continuing operations are simplified. Park managers know the drill on government approvals. And the park not only supplies basic services but also has one of Jalisco's finest soccer fields.

The park has not fully met one of Flextronics' goals--to shorten its supply chain. Among the tenants, only a few make something that is integrated into a manufactured product. The rest of Flextronics' tenants are equipment and service suppliers. As a result its supply chain is long and expensive. But so is everybody's. Guadalajara's electronics sector imports as much as $9 worth of parts for every $10 in exports. Because much is imported from the U.S., the true labor cost of electronics equipment made in Guadalajara is substantially higher than in most of Asia, where many parts are produced locally.

It would obviously benefit the Guadalajara electronics manufacturers and aid Mexico's economic development if more suppliers were Mexican-owned companies. So far they're hard to find. Most Mexican manufacturers are privately held, often family firms, not accustomed to meeting demands for high volumes, high quality, and just-in-time deliveries. Even those that might aspire to do so don't have access to the capital needed to improve their operations.

That doesn't mean they can't adjust. One that did is Ureblock, which was founded in 1978 in the western suburbs of Guadalajara to produce polyurethane foam products for the Mexican bedding and furniture industry. Still owned and managed by the founder, Francisco Herrera Marcos, 62, and his two sons, Francisco, 33, and Lucio, 29, Ureblock was approached in 1987 by IBM to make a polyurethane cushion for packing PCs. Says the younger Francisco: "This was the first customer who came asking for quality and service." With IBM's help, Ureblock responded, winning supplier quality awards, getting ISO 9002 quality certification, and expanding as orders grew from IBM, HP, and others.

Ureblock has grown from a dozen employees to 800, including 180 doing packaging right in the IBM facility. The original plant has been expanded from 20,000 square feet to 700,000, and Ureblock has new facilities in three other cities. This year, sales ought to reach $50 million, split about fifty-fifty between electronics and furniture and mattress companies. Now, says young Francisco confidently, "we think we should expand to the states."

While the ECMs press their U.S. suppliers to move to Mexico, they don't have the staff, margins, or leisure to help local companies the way IBM helped Ureblock. To try to cover the gap, Caneti, Mexico's electronics industry association, has formed a group called Cadelec. (Caneti and Cadelec are acronyms of long names in Spanish over which even members stumble.) Cadelec has organized teams of engineers and managers to teach local companies how to improve quality and production skills. It also has identified products purchased by the electronics industry that it thinks could be made in Jalisco. More than a bit ambitiously, it says there's a $2 billion annual demand to be filled.

Unfortunately, more than half of that $2 billion consists of semiconductors, resistors, and capacitors. It will be tough to persuade a foreign-based producer of these low-labor-cost, high-volume, easy-to-ship products to move south of the border. It's too easy to set up a local sales office or, simpler and more efficient, to work with a big electronics-parts distributor. One of those, Avnet, recently opened an office and warehouse in a Guadalajara suburb.

Made anxious by the decamping of some big companies and the loss of manufacturing contracts from others, some thoughtful Mexicans worry that the day will come when the contract manufacturers move away. That could happen. Says SCI's Parks, who identifies closely with the country after 19 years in residence: "In Mexico, we have to fight to be more and more competitive. I think all of us know that we can lose product to Asia."

Nevertheless, Parks and his peers point to the more promising possibility that Mexico, and particularly the Guadalajara contingent of U.S. electronics manufacturers, will continue to move up the technology chain. Flextronics' president for the Americas, Mike McNamara, believes there is already an international product path being carved out. Complex new products get made in the U.S. "Once the product becomes stable," he says, "we migrate it down to Mexico." But stuff that's simple to make in high volume and easy to ship then shuffles off to Asia. Park notes that for some customers, such as Sierra Wireless of Vancouver, he has moved all the way up the chain: "We're taking product off the drawing board, doing the first prototypes, then the early design runs, and finally launching it."

For Jalisco--and the rest of Mexico--it's going to be a tense balancing act, shifting slowly from lower-paid assembly work to better-paid production while still increasing, or at least maintaining, the number of people employed. But looking back, despite the ongoing struggles with a tough market, rising labor costs, and minor bureaucratic irritations, one company after another says it made just one major error in the move to Jalisco. It didn't come soon enough or expand fast enough. When the market gets moving again, these companies plan not to repeat that mistake. Says Mike McNamara: "This place is really going to be unbelievable."

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