The website for InFocus India, a subsidiary of Taiwan's Hon Hai Precision Industry Co. Ltd, boasts that its InFocus M808 handset is “the most iconic phone ever”.
It’s an ambitious claim for a mobile phone brand the vast majority of people outside of India will have never heard of.
Hon Hai, which also goes by the name Foxconn Technology Group, has two big problems: its established business lines are slowing and it lacks its own household brand.
The company has made much of its fortune by making cutting-edge mobile phones at its Shenzhen-based super factories for other businesses, particularly Apple Inc. And Apple’s sales are slowing.
The US electronics gizmo maker reported revenue of $75.9 billion for the final quarter of 2015, versus $74.6 billion in the same period of 2014, well below the 20%-plus year-on-year growth investors are used to seeing it report. And the company sold 74.78 million iPhones, barely more than the 74.49 million it sold in the same period of 2014.
“Apple growth is no longer that high and it is also looking at other suppliers too, while on the enterprise hardware side, [Hon Hai's] sales are growing in the low single digits per year,” Nicolas Baratte, head of technology research for Hong Kong-based brokerage CLSA, told FinanceAsia.
Hon Hai founder, group chairman, and chief executive officer Terry Gou seems to hope the $3.5 billion acquisition of Japan's Sharp Corporation will help it to rectify this weakness, by giving it a household name it can build and use to distribute its own products. He essentially sees Sharp as a well-known brand and diversification opportunity all in one, and by marrying this to Hon Hai’s manufacturing prowess he hopes to build products faster and cheaper than anybody else.
But it’s still a big gamble. Gou is taking on a loss-making company with eroding market share in some of its key businesses and enormous sums of capital injection needed are to turn it back into a genuine player, in the display panels business in particular.
“If you asked me, would I have the guts to proceed with such a large transaction? I wouldn’t,” said a person close to the negotiations. “But that’s what it takes to differentiate a visionary CEO from others.”
Doing a deal
Gou certainly didn’t walk into this without doing his homework. Hon Hai is understood to have conducted more than 100 discussions with various advisers about acquiring Sharp over the past six months alone.
These intense discussions resulted in Hon Hai being poised to sign a deal in February. But an eleventh-hour revelation that Sharp faced up to ¥350 billion ($3.1 billion) in contingent liabilities put the deal on ice and gave Hon Hai ammunition to negotiate a ¥100.2 billion drop in the price.
Sharp had little choice but to acquiesce; its only other suitor INCJ had pulled out, and if Hon Hai did so too it faced insolvency. Nikkei Asian Review reports that Sharp will report an operating loss of ¥170 billion for the full financial year that ended on Thursday, in large part because Hon Hai demanded that it include provisions for losses on inventory and other expenses. This means there is less for Hon Hai to provision against once it takes over.
Under the revised agreement, Hon Hai will invest ¥388.8 billion in Sharp through a placement of new shares at ¥88 apiece, down from the ¥489 billion originally discussed in February (the high number of eights involved likely reflects the Chinese tradition that the number eight, which sounds in Mandarin a bit like ‘fortune’, is considered lucky). It also reportedly agreed to buy ¥200 billion in preferred shares owned by Sharp creditors Mizuho Financial Group and Bank of Tokyo-Mitsubishi UFJ Group at some point in the future.
That capital increase will take Hon Hai’s stake in Sharp to 66%, could end up rising further if Sharp takes the preferred shares too. The company is believed to have committed cash to support the purchase, although banks have also committed credit lines to fund the deal.
Interestingly, Hon Hai itself will take 44.55% of Sharp, Foxconn Technology, a Hon Hai metal casing subsidiary, will take 13%, and Gou himself will personally hold 8.45% via his LCD plant in Sakai, in Japan. The person close to the discussions said this was designed to limit Hon Hai’s ownership in Sharp to less than 50%, meaning it doesn’t have to consolidate the company.
“This is part of corporate planning. Obviously you don’t want to consolidate entities when you need to conduct a turnaround over the next two to three years; you want to build firewalls,” the person familiar with the discussions said.
Nevertheless, the equity market appears a little nervous, with Hon Hai’s share price giving up most of its early gains on Thursday after the takeover was confirmed and closing at NT$84.80, just 1.3% up on the day.
Gou’s hunger to buy Sharp is evident from the amount of work he has put into buying the company.
But it’s hard to tell whether this has been a good or a bad deal, given the potential liabilities and uncertainty about how well Hon Hai will leverage Sharp’s intellectual property and brand.
Analysts note that Sharp has a decent cash flow and Nomura estimates it will have sales of ¥2.45 trillion for the 2015 financial year. But it’s hard to escape the fact Sharp is losing money heavily and that its market share is decreasing in key areas.
Sharp is already a miniscule player in global smartphone production. Even at home its market share declined from around 14% in mid 2014 to 6% by November of that year, before recovering to about 10% at the end of 2015.
It’s falling behind in display technology too. Apple is reportedly looking to switch to OLED displays for its phones as soon as 2018. And Sharp lacks the ability to produce such displays, whereas Korean companies Samsung and LG Display look to have $15 billion of capital expenditure earmarked to expand their manufacturing of OLED displays, CLSA's Baratte said.
“It’s not clear that Apple needs a third supplier to produce its displays,” he said.
But it seems Gou disagrees. Another Taipei-based equity analyst who covers technology stocks told FinanceAsia that he had visited Sharp a week before and that company executives had told him that plans to create OLED manufacturing capabilities are in the offing – but that they aren’t likely to be working at full capacity until 2019.
Building these capabilities is likely to cost Gou a lot more money. The latest announcement from Hon Hai mentioned investment plans of ¥200 billion. “I think it will most likely cost multiple times that,” the equity analyst said.
Yet Gou’s obvious desire to gain Sharp means he is prepared to invest such large sums for what is effectively his first brand acquisition.
Gou’s reasons are multifarious. “It could take us 24 hours to go into all the plans he has,” the person familiar with the discussions said. However, they appear to combine technology, brand, and business strategy, largely in that order.
On the technology front, Sharp may not sit at the front of the queue for display technology any more but it still boasts a leg up on Hon Hai’s own display subsidiary Innolux.
“Sharp has technology that’s incrementally better than what Hon Hai has today, so they can get technology that’s still good, although not the most advanced,” said the equity analyst.
More importantly, Sharp possesses several patents in display technology that Gou believes to be valuable sources of intellectual property.
Sharp’s business could potentially benefit Hon Hai’s low-cost, fast delivery model too.
One reason the Japanese electronics company has struggled is because its costs have been too high and it has lacked the capital to invest in research and development. Hon Hai offers both.
Hon Hai believes its manufacturing capabilities could prove particularly helpful for Sharp’s appliances business and its ailing printer business. Meanwhile, the latter’s brand name could provide sales appeal to these products that Hon Hai could not enjoy under its own name.
“Building a brand takes years and years and costs a lot of money,” Baratte told FinanceAsia. “But the Sharp brand offers Hon Hai that, plus it has a big appliance brand business in Japan and a smaller one across Asia, with good design quality and competitive costs versus rivals like Electrolux.”
The Sharp brand is well known and generally respected for offering quality products, despite having lost market share over the past decade. That immediately offers Hon Hai a potential lift. It also provides the company with greater income diversity, particularly with Sharp’s appliances sector.
Gou’s rationale for buying Sharp appears very much set on Hon Hai’s evolution from being a builder of other people’s devices to an international brand in its own right. He seems to believe that building product distribution and sales under the Sharp name offers Hon Hai its next stage of evolution.
It could provide Hon Hai with the opportunity to take Sharp’s brand and appliances business and expand it globally, particularly in large, mid-market areas such as India and Africa. And it could well lead Sharp’s ailing smartphone business to enjoy a new lease of life.
A risky approach
But as bold as the strategy is, it’s risky. Sharp has lost ground in smartphone manufacturing and distribution, printing, and displays, all of which are highly competitive markets.
Hon Hai might be able to turn these around but it’s by no means assured, particularly in the smartphone arena. Many rivals have failed to make smartphone companies work after acquisitions.
“It was once said [by Vic Gundotra, the former Google senior vice president who spearheaded Google Plu] of Nokia looking to build Windows phone handsets, ‘two turkeys don’t make an eagle',” the Taipei-based equity analyst said. “And Lenovo acquired Motorola and they are struggling outside of the US and Latin America, [recording an 18.1% year-on-year drop in sales in the fourth quarter of 2015]. And Sharp isn’t doing well at all.”
Even in the appliances sector, where Sharp’s name shines more brightly, is seeing consolidation; in January Chinese white goods maker Haier bought rival GE Appliances for $5.4 billion, in a desire to build global distribution.
Hon Hai possesses the cash and the manufacturing grunt to help renew Sharp’s business. Now Gou needs to prove his company has the execution capabilities too.
The technology world will be watching with baited breath to see if he can succeed.
Hon Hai was financially advised by JP Morgan on the M&A, while Sharp was advised by Mizuho and Mitsubishi UFJ Morgan Stanley Securities.
Story amended to reflect that Hon Hai Precision bought 66% of Sharp in common stock, and has reportedly agreed to buy preferred shares from Sharp creditors in the future.