Foxconn trots out IPO

Pre-marketing begins for Hong Kong''s first benchmark IPO of the year.

Pre-marketing began this Tuesday for a $300 million to $400 million IPO by Foxconn International Holdings (FIH), the telecom handset  manufacturing arm of Taiwan's Hon Hai group. Under the lead management of Goldman Sachs and UBS, formal roadshows for the Hong Kong listing will begin on January 17, with pricing scheduled for January 25 and listing on February 3, just ahead of Chinese New Year.

The deal is being marketed on a 2005 P/E range of 11.2 to 14 times forecast earnings based on the syndicate's average net income assumption of $235 million. Pre greenshoe the company is offering 12.5% of its enlarged share capital.

It will comprise all primary shares and pre greenshoe this will see the Hon Hai group drop from 85.1% to 74.8% and company employees from 15% to 12.7%.

Analysts expect the handset arm, whose operations are largely based in Shenzhen, to be the main growth driver for Hon Hai's earnings over the next few years and should contribute roughly 18% of group revenue in 2004, up from 10% in 2003. The parent is currently trading on a 2005 P/E ratio of about eight times earnings.

Since Hon Hai established a handset arm in 2001, growth has been exponentially high. Between 2002 and 2003, for example, revenue grew from $272 million to $1.09 billion and net profit from $35 million to $101 million.

Between 2003 and 2004 syndicate analysts are forecasting net income growth of about 78% to $180 million, with a further jump of 25% or so to $235 million in 2005. 

Growth has been driven by the same outsourcing trend that previously enabled Taiwanese Original Design Manufacturers (ODM's) such as Hon Hai and Compal to capture significant global market share in PC production from Original Equipment Manufacturers (OEMs) like Dell and Hewlett Packard.

In the telecoms sector these OEM's are global giants like Nokia, Motorola, Sony Ericsson, Samsung Electronics and Siemens. Between them, the five account for nearly two thirds of global handset sales, with Nokia enjoying a roughly 30% market share, Motorola 15%, Samsung about 12%, Sony Ericsson 7% and Siemens 7%.

Vendors have adopted two approaches. Nokia and Samsung still largely employ vertically integrated models where virtually everything - from R&D through manufacturing to branding and sales - is done in-house. Others have embraced outsourcing and decided to place greater in-house emphasis on their own core competencies in branding and sales.

Analyts estimate that Motorola outsources about 22% of its overall production and Sony Ericsson about 35% - virtually all of which is manufactured by Flextronics, the world's largest contract manufacturer.

In 2004, Foxconn is expected to jump into the second spot behind Flextronics reporting a 5% global market share, with shipments of just over 30 million handsets. This will also mean that it has leapfrogged BenQ, Taiwan's largest handset manufacturer, which is expected to report shipments of 16 million handsets.

According to research by Strategy Analytics, third party manufacturers should see their total market share rise from 30% in 2003 to about 38% by the end of 2007.

Analysts say the outsourcing rationale is largely being driven by cost considerations. As the global cellular sector gets every more competitive, vendors have taken a strategic decision to push some of the R&D expenses and associated business risks onto outside manufacturers.

This also enables them to cut the lead-time of new products to market. In turn, vertically integrated manufacturers like Foxconn have an advantage over second and third tier players because they can internally source components more cheaply and derive better synergies. Hon Hai group companies, for example, make casings, connectors and LCD modules. They also derive a cost advantage from being China based.

Some ODM manufacturers such as BenQ have also started to branch out into their own branded products and in 2004, the group became the second largest handset vendor in Taiwan after Nokia.

Foxconn's three largest clients are Motorola, Nokia and UTStarcom, which together account for 89% of overall revenue.

Analysts say that most of the company's growth will derive from better penetration of its existing clients and winning new ones rather than overall industry growth. Many predict that the strong global demand evidenced over the last two years is unlikely to be sustained in 2005.

In 2003 and 2004, for example, global handset shipments recorded a CAGR of just over 20% to about 670 million units and sales of $100.9 billion. In 2005, global growth is expected to fall back to 2% in line with levels achieved in 2002.

Analysts say this is because new subscriber growth is slowing in developing countries and upgrades in the rest of the world await mass 3G deployment. In China, many analysts also report significant oversupply of handsets at the bottom end of the market, where domestic companies like Ningbo Bird are pushing aggressively. In 2004, China's largest domestic handset manufacturer is expected to report final shipments of about three million units.

Analysts forecast that global demand will start to accelerate again towards the end of 2005 and through into 2006.

Specialists believe Foxconn's biggest selling point is its scale and pure play status for those investors that just want exposure to the handset sector. Comparables such as Flextronics and BenQ only derive about a quarter (BenQ) to one third (Flextronics) of their operating profit from handset production.

Other listed pure plays such as Taiwan's Compal Communications are much smaller in scale. In 2004, Compal is expected to report shipments of about eight million units, one quarter the size of Foxconn.

Nasdaq-listed Flextronics is currently trading on a 2005 P/E ratio of about 19.5 times, while BenQ stands at 12 times and Compal at 9.5 times. A year ago, before the tech sector began its long decline through 2004, Compal was trading at 17 to 18 times forward earnings.

Globally, OEMs such as Nokia and Motorola are trading on respective 2005 P/E's of 17.5 times and 15.5 times. At the top end of its 11 to 14 range, Foxconn will come at discount to the global comps.

As well as P/E, specialists say that some investors are looking at EV/EBITDA. On this basis, the stock is being marketed on a 2005 ratio of 7.5 to 9.5 times. Nokia is currently trading at 8.1 times, Motorola 9.3 times and Flextronics 8.2 times.

Like Flextronics, Foxconn is not expected to pay a dividend. Nokia, by contrast is currently yielding 3.3% (forward) and Motorola 1%.

There is also a big difference where margins are concerned. Nokia and Motorola both sustain operating margins in the high teens, whereas Flextronics is forecast to report an operating margin of about 5% in 2005 and Foxconn about 6%.

Both Flextronics and to a lesser degree Foxconn are considered Electronic Manufacturing Services (EMS) companies rather than pure ODM's and because of this the IT and logistics support they need to provide their clients increases their cost structures.

But arguably the biggest risk the deal faces is market sentiment. The liquidity rally evident at the end of 2004 has not as yet carried over into 2005.

As one banker puts it, "Accounts have spent the entire first trading week taking profits. Our sales head says he can't remember any other year that’s got off to such an inauspicious start. Lets hope the old adage that the first week's performance dictates the pattern for the rest of the year does not hold true for 2005."

On the plus side, Foxconn currently has the market to itself and with Chinese New Year looming some bankers believe it may stay that way for another month.

Alongside Goldman and UBS, co-leads are ABN AMRO and Morgan Stanley, with Chinatrust, Daiwa SMBC and Taishin acting as co-managers.