While the growing tariff dispute between the U.S. and China has yet to devolve into an all-out trade war--with limited effects on either country's economic output so far--certain industries could soon feel the impact. This holds true for the global technology sector, which has an extensive global supply chain in which China plays a big role.
In April, the U.S. released a list of proposed tariffs on more than 1,300 Chinese goods--including components for aircraft, industrial tools, pharmaceutical and medical supplies, and various home goods. The Trump Administration developed the list in response to what it considers China's efforts to unfairly obtain technological and intellectual property. Though U.S. government officials and agencies vetted the list to exclude items that could backfire at home, technology companies, consumers, and investors are worried about the potential effects on the global technology industry.
The following are questions and answers relevant to the issues.
How does S&P Global Ratings view the ongoing U.S.-China trade tensions with respect to the global technology sector?
We believe the U.S.'s proposed 25% tariffs on up to about $50 billion of Chinese imports will have a subdued impact on the global technology sector. However, we also believe the Chinese Ministry of Commerce's proposed 25% tariff on $50 billion worth of U.S. exports in retaliation and the Trump administration's instruction to the U.S. Trade Representative to consider another $100 billion tariffs against China shortly thereafter to be highly problematic. The rapid sequence of events lowers the probability of negotiation and settlement between the two countries and heightens the chance of a trade war that could hurt overall global economic growth—and particularly the global technology sector.
The list of products subject to U.S. tariffs include more than 1,300 imported goods, such as aerospace technology, industrial machinery, medical equipment, medicine materials, and much more. However, conspicuously absent from the list are products that would cause significant disruptions to the U.S. economy or consumers such as personal computers, laptops, cell phones, servers, or telecom equipment--even though they represent a large proportion of U.S. imports (see chart 1).
Among the technology products on the proposed U.S. tariffs list were hard disk drives (included as data processing equipment and parts in chart 2, below) and flat-panel televisions. We think the effect of tariffs on U.S. imports from the currently identified list of products will be minimal, given the small amount and manufacturers' ability to source from other foreign producers (e.g., hard disk drives from Thailand and flat-panel displays from Taiwan). Still, we recognize that other products subject to the tariffs, such as industrial equipment and robotics, automobiles, medical equipment, and electronic and semiconductor content, would likely lead to higher prices and lower demand for the components that go into these products if there are no substitutes.
Similarly, China's proposed $50 billion tariffs also excluded a large U.S. export item: semiconductors. We believe that semiconductors are exempt because many don't have substitutes. Moreover, including them would hinder China's ambition to accelerate its competency in the advanced information and communication technology areas, such as mobile internet, cloud computing, big data, and the internet of things, among other emerging technologies. In June 2014, the State Council of China released the "National Guidelines for Development and Promotion of the Integrated Circuit Industry," its national policy to help spur innovation by investing more than $150 billion over the next decade into the country's semiconductor industry to help it become self-sufficient and reduce imports from foreign suppliers. In May 2015, the Chinese State Council announced its "Made in China 2025" policy, which focuses on building indigenous capabilities in high-end manufacturing, with the goal of promoting self-reliance in many areas over time, including semiconductors, electronic equipment, marine equipment, advanced rail, agricultural machinery, aerospace equipment, medical equipment, robotics, new energy vehicles, and advanced materials.
We suspect this is also a factor in the U.S. Trade Representative's decision in August to use Section 301 of the Trade Act of 1974 to initiate an investigation into China's violations of U.S. intellectual property rights and other unfair technology transfers, which potentially threaten U.S. firms by undermining their ability to compete fairly in the global market. We think the investigation aims at penalizing China for its trade practices but also slow China's technological advancement toward becoming a longer-term threat to the U.S. technology leadership position.
Does S&P Global Ratings believe the simmering trade tensions could intensify?
We think the trade controversy between the U.S. and China remains fluid. The proposed U.S. tariffs will undergo further review in a public notice and comment process, including a public hearing on May 15 before the U.S. Trade Representative issues a final determination.
If the tariffs are approved, trade tensions could escalate. The tech sector would certainly see tariffs on an even broader set of products as more distressing than those currently on the table. The cost of goods would undoubtedly rise--or worse, the tariffs could disrupt the sector's supply chain. The effects of higher prices would be felt along the entire supply chain, especially in Korea, Japan, Taiwan, and other Asian countries. This would also hurt consumers globally. Beside tariffs, China could also push local companies and consumers to boycott American products, which isn't unprecedented, and would be harmful to U.S. businesses.
What, if any, implications might a trade war have on mergers and acquisitions in the global technology industry?
The Committee on Foreign Investment in the U.S. (CFIUS), a U.S. government interagency committee that reviews national security implications of foreign investments in U.S. companies and operations has recommended the blocking of two recent takeover proposals involving U.S.- and China-based companies. This past September, following the recommendation of CFIUS, President Trump blocked the proposed $1.3 billion acquisition of Lattice Semiconductor Corp., a U.S. chipmaker, by Canyon Bridge Capital Partners LLC (unrated), a U.S.-headquartered private equity firm reportedly funded by the Chinese government. The deal was thwarted because of potential national security risks that couldn't be addressed through mitigation measures. In addition, President Trump blocked Broadcom Ltd.'s $117 billion hostile bid for Qualcomm Inc. in March over concerns that Broadcom would cut research and development spending at Qualcomm, weakening the company's ability to compete against foreign rivals, namely China's Huawei Technologies Co. (unrated), in the development of the next generation cellular networks (5G). Qualcomm's proposed $44 billion takeover of NXP Semiconductors N.V., a Dutch global semiconductor manufacturer, is currently awaiting approval from China's Ministry of Commerce (MOFCOM). The proposed transaction was announced in October 2016 and has received all regulatory approval except that of MOFCOM. The slow pace of approval is likely a result of the political climate between the U.S. and China.
How might an all-out trade war affect credit ratings in the tech industry?
We are hopeful that the U.S. and China will be able to come to terms and avoid escalating trade tensions because we believe an all-out trade war would not be in the best interest of either country--or any other country for that matter. From the American perspective, retaliation with tariffs or engaging in a trade war isn't the primary objective. Rather, it's to put a stop to China's alleged intellectual property (IP) theft, forced technology transfers from multinational companies investing in China, and to ease the current limits on foreign ownership of Chinese enterprises. On the other hand, China would like to close the technological skill gaps with global powerhouses in order to gradually reduce dependence on foreign technology. However, we believe that China will continue to rely on foreign expertise and imported technology for the foreseeable future. If China's ambition is to become a global technology powerhouse, it would require not only significant improvement in their indigenous technology innovation know-how but also an open market policy that encourages fair trade practices.
Our base case is one of limited ratings impact. Certainly, should the trade dispute ratchet up, we would need to re-evaluate the effects on the technology sector.
When will S&P Global Ratings resolve its CreditWatch placement of Qualcomm and, if the merger doesn't close, what are the rating implications?
S&P Global Ratings placed Qualcomm's ratings on CreditWatch with negative implications on Feb. 20, 2018, after the company increased its offer for NXP Semiconductors to $127.50 per share from $110. The CreditWatch placement reflects our view that the higher offer, to be funded with cash on hand and new debt, could raise Qualcomm's pro forma adjusted leverage to the near mid-3x area, which exceeds our previous expectation of adjusted leverage above mid-2x at the close of the deal and below 2x within two years. We also indicated that if the transaction closed as proposed, we could lower our corporate credit rating on Qualcomm by one notch. We usually place a rating on CreditWatch if we determine that there's at least a one-in-two likelihood of a rating change within 90 days.
Two months after we placed Qualcomm on CreditWatch, and a year and a half since the acquisition announcement, the companies have yet to cross the finish line. On April 16, at the request of MOFCOM, Qualcomm and NXP withdrew and refiled the notice of acquisition seeking Chinese regulatory approval. The refiling gives MOFCOM another six months to review the application. Given the ongoing trade tensions with China, S&P Global Ratings can't predict when and if China will approve the acquisition. However, assuming U.S.-China relations don't deteriorate, we expect MOFCOM and Qualcomm will eventually reach an agreement because we don't think there are anti-trust grounds for a rejection. Until then, we're likely to maintain Qualcomm's ratings on CreditWatch beyond the 90-day period initially envisioned.
If MOFCOM rejects the proposal and Qualcomm is forced to abandon its bid, we would undertake a fresh review of our ratings on the company as a stand-alone entity. Before the NXP announcement and related challenges with its largest customer Apple Inc., we rated Qualcomm 'A+'. We've always maintained that the NXP acquisition was critical for Qualcomm's long-term success as its wireless business continues to face significant customer concentration risk. The Qualcomm Technology Licensing (QTL) segment, at its peak, accounted for roughly one-third of the company's revenues and more than 80% of its profits through its leading wireless IP portfolio. Since Apple and another unnamed customer began withholding royalty payments to Qualcomm early last year, its financial results have deteriorated significantly, with fiscal 2017 QTL revenues declining 16% and Qualcomm's overall free operating cash flow falling 42%, to roughly $4 billion.
In our review of Qualcomm's business, we'll analyze the sustainability of its royalty model over the longer term. We expect the company will eventually reach an agreement with Apple but the terms will likely be less favorable for Qualcomm. We'll review Qualcomm's baseband business and potential for share loss to competitors such as Intel Corp. or MediaTek Inc. (unrated). The baseband business is included in the company's Qualcomm CDMA Technologies (QCT) segment, which accounted for 74% of the company's revenue and 17% of its earnings before taxes in fiscal 2017. We'll also review Qualcomm's ability to maintain its technological leadership as the industry transitions from 4G to 5G over the next decade and whether its business model will continue to be challenged by regulators and customers in the new 5G environment.
Finally, we would meet with Qualcomm's management to assess its "new" financial policy in the event of a deal breakdown. Qualcomm will likely have a strong balance sheet as a stand-alone entity but we would discuss its intentions regarding the debt already raised as part of the NXP financing (some tranches of notes issued in May 2017 have mandatory redemption features in case of a deal breakup) and potential for enhanced shareholder returns given the underperformance of its stock since the NXP announcement. Broadcom, for example, announced a new $12 billion stock repurchase authorization after its bid for Qualcomm was derailed.
As for NXP, we placed its 'BBB-' corporate credit and issue-level ratings on CreditWatch with positive implications in October of 2016 following Qualcomm's announcement to acquire NXP. Our expectation has been that at closing we would raise our corporate credit rating on NXP to the same level as Qualcomm depending on our assessment of Qualcomm's and NXP's parent-subsidiary relationship. We would also notch NXP's debt rating based on Qualcomm's capital structure post-closing. However, if the transaction doesn't take place, we would resolve the CreditWatch placement by assessing NXP on a stand-alone basis. We would discuss with NXP management its future business strategy and capital structure plans including financial policy (its current reported net debt to EBITDA was just below 1x at the end of last year, which is significantly lower than the previously stated financial policy target of at or below 2x, and may not reflect the future capital structure of a potential stand-alone NXP).
How does Broadcom's recent $12 billion share repurchase authorization affect S&P Global Ratings' view of its financial policy and credit rating?
Historically, Broadcom's largest use of cash was for M&A and it showed a willingness to pursue increasingly larger debt-financed acquisitions. However, its execution on cost cuts and rapidly declining debt leverage to stated boundaries have been impressive. Following President Trump's blocking of Broadcom's attempt to acquire Qualcomm, Broadcom's management stated that it continues to prefer acquisitions to buying back shares or paying down debt. On April 12, Broadcom said its board approved a $12 billion buyback effective immediately until Nov. 3, 2019 (end of fiscal year). We find Broadcom's buyback program and its existing policy of delivering 50% of free operating cash flow to shareholders in dividends an indication of its shareholder-friendly financial policy. We believe Broadcom will remain active on the acquisition front but we don't believe a takeover of comparable size is likely. Management also noted that it would likely fund future M&A with cash on hand without the need to raise net leverage past 2x. We view the buyback program as a means to provide the company the flexibility to enhance shareholder returns if M&A opportunities don't exist.
Broadcom's adjusted leverage was about 1.3x on Feb. 4 (end of fiscal first quarter 2018), with contribution from the Brocade Communications acquisition beginning Nov. 17, 2017, compared with leverage of 1.8x a year earlier. It's our belief that Broadcom favors M&A over share repurchases. Given our expectation for continued solid revenue growth and EBITDA-margin expansion and estimated free operating cash flow of at least $7 billion in each of the next two fiscal years, leverage will likely remain below 3x through fiscal 2019, absent any large scale acquisitions.
Our corporate credit rating on Broadcom Ltd. is 'BBB-' with a positive outlook. The outlook reflects our expectation that Broadcom's consistent operating performance and ability to generate substantial free cash flow will provide financial flexibility for future acquisitions while maintaining adjusted leverage within the 2x-3x range. We would upgrade the company if it continues to maintain a consistent financial policy with adjusted leverage below 3x, incorporating increases for M&A and shareholder returns.
|Primary Credit Analysts:||David T Tsui, CFA, CPA, New York (1) 212-438-2138;|
|Andrew Chang, San Francisco (1) 415-371-5043;|
|Jenny Chang, CFA, New York (1) 212-438-8671;|
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