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Business trends

Apple suppliers brace for profit slide as gadget sales slow

Taiwan's contract manufacturers hope AI era will bring orders boost

TAIPEI -- Many major contract manufacturers for Apple have been suffering since the beginning of 2018, hit by a sharp decline in profits and fierce competition with peers to grab more orders amid lackluster hardware sales.

Five key Taiwanese contract manufactures that help make Apple products -- Hon Hai Precision Industry, Pegatron, Quanta Computer, Compal Electronics and Inventec -- together suffered a 35% drop in combined operating profit from a year ago in the first three months of this year, or some 18 billion New Taiwan dollars ($602 million). Each of the five -- which help make iPhones, iPads, MacBooks, Apple Watches and AirPods -- saw a double-digit percentage year-on-year contraction. Four out of the five even recorded an operating profit margin below 1.5% in the period.

The accumulated gross profit of the five companies fell nearly 13% year-on-year over the same period, with each one of the companies' gross margins also shrinking from a year ago, despite a nearly 6% rise in their combined revenue from a year ago.

Although their top client Apple reported better-than-expected earnings, with net profit reaching its highest level for the March quarter, growth was mostly from cloud services. Apple's hardware product unit sales, a lifeline for these contract manufacturers, slowed substantially. Apple only sold 3% more iPhones and 2% more iPads than a year ago, while it saw a 3% year-on-year decline in Mac shipments in the period.

Shares of major iPhone assembler Hon Hai, better known as Foxconn, have dropped more than 10% since the beginning of this year, while key MacBook and Apple Watch maker Quanta's shares have shed more than 15% so far this year. Smaller iPhone assembler Pegatron, iPad manufacturer Compal and Inventec, have all seen their stock prices declining this year. Inventec's unlisted subsidiary Inventec Appliance is a major AirPods and HomePod supplier. Apple's shares, on the other hand, have advanced more than 10% so far this year.

These contract manufacturers have been expanding their revenue base to boost razor-thin profit margins, alongside the smartphone boom of the past few years. However, lukewarm demand and Apple's strategy of diversifying suppliers have intensified price competition within the supply chain as companies compete for more orders. Most of these companies' production facilities are in China, so they also face uncertainties amid trade tensions between Washington and Beijing, and could be hit harder if tariffs are imposed on electronic products.

Even though the smartphone industry's growth momentum is slowing, the iPhone assemblers have not stopped expanding production capacity -- Pegatron invested between $350 million and $400 million, and Wistron poured nearly $300 million into capital spending last year. As a result, they also face the conundrum of how to increase low production utilization rates, which have further fueled price competition.

"We think the competition among suppliers is more intense than ever and their biggest client [Apple] is cutting pricing on everyone, given that the hardware sales are weak," said Vincent Chen, an analyst at Yuanta Securities Investment Consulting.

Rising Chinese rivals also pose an emerging threat to the long-existing Taiwanese assemblers, which enjoyed dominance in the Apple supply chains for years. Luxshare Precision Industry, better known as Luxshare-ICT, is one of the most aggressive China-based Apple suppliers. It climbed from being a connector and cable-maker in 2013 to become the second-biggest assembler of AirPods in the fourth quarter of last year.

Luxshare even poached engineers familiar with production processes by offering salary packages three times those at AirPods maker Inventec's facilities in Shanghai in order to manage more orders from Apple and solve quality issues in assembling the wireless earpieces, according to an industry source.

The rise of its Chinese rival is part of the reason behind Inventec's gross margin fall in the quarter ended in March, the Taiwanese company confirmed. Inventec said it is gearing up to increase capacity and lower production costs for AirPods in order to secure its orders against competition from Luxshare.

As the contract manufacturers struggle to deal with growing competition within the supply chain, they are also looking for new growth drivers in artificial intelligence, the Internet of Things, and future electric cars. However, those nascent areas have not yet become main revenue sources. Foxconn, Quanta and Pegatron still count on Apple for more than half of their revenue, while all the key executives are keen to look beyond their big U.S. client.

Foxconn's Chairman Terry Gou said his company was facing a critical transformation period. The company is focusing on developing industrial internet-focused solutions for "smart" manufacturing, and then to develop smart healthcare and security solutions based on big data collection and analysis. The upcoming listing of Foxconn Industrial Internet (FII) on the Shanghai Stock Exchange is part of the parent's corporate transformation plan.

"Foxconn will fully develop smart manufacturing, doing our best to become the bellwether in the fields of internet, big data and artificial intelligence in China's real economy," Gou said in a speech at Tsinghua University in Beijing on Wednesday.

Quanta's Chairman Barry Lam said key areas his company would tap into included hardware related to artificial intelligence and augmented reality, but he was not sure how long these new opportunities would take to make a big revenue contribution.

"In the AI era, the hardware and applications are more fragmented in various dimensions, from consumer electronics, business, industrial uses to smart city ... We need to invest in a wide range of areas to grab these new opportunities," Lam told reporters. "We are confident that the next significant technology evolution would come from AI, but we are not sure about the timing [over which] it really becomes a major growth engine."

Pegatron Chairman Tung Tzu-hsien said in a recent interview with the Nikkei Asian Review that the era of fast growth in the mobile industry had passed, and his company was seeking new drivers for future growth, including voice-activated smart speakers, connected devices and electric cars. However, all those areas will still take time to bear fruit, said Tung.

"This year, we currently don't see a growth catalyst for the Taiwanese hardware supply chain in a consumer electronic downturn, while they are not that quick to tap new growth engines such as electric cars," said Arthur Liao, an analyst at Fubon Securities. "Investors are a bit cool over pouring money into stocks of these hardware suppliers too."

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