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What is Foxconn's strategy in buying Sharp?

Hon Hai Chairman Terry Gou said on Jan. 31 that he is confident his bid to acquire Sharp will be successful.

TAIPEI -- When Japanese electronics giant Sharp Corp. said on Thursday that it would devote more resources to audit a $5.95 billion acquisition offer from Hon Hai Precision Industry than it would a state-backed rescue plan, the announcement appeared to be a surprise victory for Terry Gou, the founder and chairman of the Taiwanese iPhone assembler.

     Yet it is a confounding bid from the manufacturing giant, also known as Foxconn Technology Group. It has been trying to diversify away from hardware businesses against a backdrop of falling demand for smartphones and mobile gadgets, including iPhones, so it is somewhat puzzling that Foxconn has been intent on acquiring Sharp, whose business is focused on liquid crystal display panels.

     The panels industry has been hard hit by a supply glut created by Chinese companies. Sharp has been bleeding money, and major Taiwanese panel makers AU Optronics and Foxconn-controlled Innolux are not faring much better. A source close to the company called Gou's move a "gamble".

     "Chairman Gou has been investing in capital-intensive sectors and that could become a huge gamble for him," said a person familiar with Foxconn's development strategies who did not want to be named. Foxconn did not respond to interview requests.

     "Yet he has already invested a significant amount of money in Innolux, which is losing money, and if Gou does not try to bolster and boost his panel business, it means his initial investments will come to nothing," the source said. "Now with iPhone adopting new panel technologies, naturally he wants to obtain Japanese technology to maintain his key position in the supply chain."

     In 2010, Foxconn completed the $5.3 billion acquisition of Chi Mei Optoelectronics via a share swap between Chi Mei and Foxconn-controlled Innolux. Due to the global supply glut, Innolux's profits had dwindled in 2015. It posted a net loss of 6.72 billion New Taiwan dollars ($201 million) in the three months through December.

Treasure trove

"Gou has been considering Northeast Asia as a treasury of advanced technologies," the source said. "He had been actively exploring the possibilities of acquiring technology from Japan before the Chinese economy slowed down, and at one point, the Japanese government was also happy to partner with Taiwanese companies to secure a share of the Chinese market."

     He said, however, that rising tensions between Washington and Beijing became an issue for Tokyo, which was now more hesitant to work with Foxconn, a company with close ties to China.

     "For Foxconn though, it is trying to get into every new field ranging from cloud to driverless cars because Gou is very anxious about the faltering demand for smartphones across the globe, and he is trying to diversify sources of revenue," the person said.

     That anxiety is well-founded. Apple forecast the first drop in revenue in 13 years for the current quarter. The U.S. tech titan contributes about half of the Taiwanese manufacturer's revenue. Furthermore, Foxconn also counts American personal computer maker HP as a key client which contributes over 8% to its revenue, but demand in that sector has shrunk significantly over the years.

     Foxconn has missed its 10% revenue growth target since 2013. In 2015, the company reported record revenue of NT$4.48 trillion, but that was only a 6.4% increase from 2014.

     As such, Gou had repeatedly said that Foxconn would deploy significant resources in new technologies such as cloud computing, big data and robotics. These have yet to contribute significantly to the company's revenue, however.

Under pressure

Foxconn could come under more pressure in the near-term, said Vincent Chen, an analyst at Yuanta Securities Investment Consulting, with Apple forcing suppliers to cut prices.

     There has been widespread speculation that Gou's strategy in buying Sharp is to gain control over its advanced display technology, so that Foxconn can supply iPhone panels to Apple too. Others said that Gou has wider designs for Sharp.

     "If Foxconn gets Sharp but Apple decides not to go with them in the end, Foxconn can still sell the panels to other smartphone makers," said Chen. "Further, Foxconn has been trying to develop and commoditize medical equipment business and that is one field that Sharp is also involved in."

     Another analyst agreed. "Sharp's small and medium-sized panel technologies can remedy Foxconn's weaknesses in this market and boost its offerings for connected devices and smartphones in the future," said Arthur Liao, an analyst at Fubon Securities.

     But both Chen and Liao pointed out that Foxconn could face a cash drain should the Sharp deal go through.

     "Sharp's debts will eat significantly into the cash Foxconn has, and this might have a negative impact on Foxconn's cash dividend in the future," Chen said.

     Sharp's debts at the end of December stand at 521.9 billion yen ($4.44 billion), after deducting its cash, time deposits and restricted cash. Hon Hai's cash and cash equivalents amount to NT$ 647.2 billion at the end of September.

Nikkei staff writer Chien Chia-hung contributed to this report.

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