- A recent ramping up of U.S. actions against Huawei puts about US$25 billion in revenue at risk across our rated Asia-Pacific technology firms.
- There will be winners and losers as many companies lose their ability to do business with the world's biggest telecoms gear maker.
- Foundries such as TSMC and SMIC will likely have to find new clients to fill large sales gaps left by Huawei, but strong demand may help a recovery in 2021.
The effects of the U.S.-China strategic confrontation are spreading. The U.S. Department of Commerce (USDC) in May cut Huawei Technologies Co. Ltd.'s access to U.S. technology to make semiconductors offshore. S&P Global Ratings expects the act will reverberate across Asian tech firms that trade with Huawei, the world's biggest telecoms equipment maker. While we anticipate operational upheaval as firms adjust to this new reality, the ultimate revenue and ratings effect may be moderate.
The new restriction will exert a direct revenue hit on several companies. We estimate that it could affect as much as 15%-20% of revenues of foundry companies such as Taiwan Semiconductor Manufacturing Co. Ltd. (TSMC) and Semiconductor Manufacturing International Corp. (SMIC). There could be secondary hits to other Asia-Pacific technology firms.
We estimate the new regulation may affect nearly US$7 billion of revenues from our rated Asia-Pacific technology issuers, and a further US$18 billion may be indirectly at risk due to their exposure to companies on the USDC Entity List.
Asia Tech Dodged A Bullet In 2019, But Challenges Arise In 2020
In 2019, our Asia-Pacific technology issuers did not experience any rating hit related to Huawei's inclusion on the USDC Entity List, as was discussed in our report "Credit FAQ: Bans On Huawei Will Hit Tech Harder Than Telecom, But Not Enough To Move The Ratings," published June 12, 2019 on Ratings Direct. Though we anticipated some modest interruption, most Asia tech issuers' operations were not affected.
However, the U.S. Bureau of Industry and Security on May 15, 2020, added restrictions that prevented certain technology companies worldwide from doing business with Chinese companies on the USDC Entity List, such as Huawei and Hangzhou Hikvision Digital Technology Co. Ltd.
These expanded rules hit in particular companies that provide U.S. software for chipset design or chipset production (foundries) that use certain U.S. technology or manufacturing equipment. Such companies must obtain a license from the U.S. government to continue servicing Huawei, otherwise they may also face restrictions from obtaining U.S. technologies (equipment, software, components) that are critical to their operations.
Prior to the ruling, the performance of our Asia-Pacific rated foundries--notably TSMC and SMIC--were stable in 2019, with single-digit percentage revenue growth. Strong investment in 5G mobile communications and cloud services drove those revenue gains, as likely did inventory stockpiling by firms such as Huawei and Hikvision, which were buying components in anticipation the U.S. would further restrict their purchases. During 2019, Huawei's inventory days increased by more than 40% to 114 days for the year.
We believe that the inventory build and investments in cloud services and equipment sales related to work-from-home have helped the Asia-Pacific foundries maintain significant growth in the first half of 2020. This comes despite a slump in consumer consumption of discretionary items such as smartphones.
COVID-19 induced lockdowns have prompted corporations worldwide to spend more on servers and personal computers for remote working and online sales. According to IDC, a researcher, global personal computer shipments grew 11.2% year on year in the second quarter of 2020, a level not seen for several years.
However, we now anticipate that Asia-Pacific foundry sales will slow in the second half of 2020 and the first half of 2021. If no licenses to sell to Huawei are granted, the new restrictions will take effect on September 14, 2020. The restrictions could amplify the negative effects on demand from the COVID-19 pandemic, as the initial spike in enterprise IT spending fades. A recovery is likely in the second half of 2021 given our expectation for a global economic rebound in 2021.
The new restrictions will not likely directly affect electronic manufacturing services given their low reliance on U.S. technology or equipment. So far the U.S. restrictions have not greatly affected Asian electronic manufacturing service firms or their dealings with Huawei.
However, the latest measures could result in significant and sudden shifts in customer orders as Huawei's operations are disrupted, and as its competitors fill in the gaps. Hon Hai may offset the decline in smartphone and communications equipment orders from Huawei with other clients, such as Apple Inc. and Xiaomi Corp.
Memory manufacturers are also unlikely to be subject to the restrictions given memory products are fairly commoditized. During the first half of 2020, memory players have shown a resilience to COVID-19 owing primarily to robust demand for server DRAM (dynamic random access memory chips) and solid-state drives stemming from rising data consumption needs. Although memory players are likely to face ongoing uncertainties on Sino-U.S. tensions, growing demand should help mitigate some of the potential strains.
Huawei Could Compete More Directly With Xiaomi In China
A possible consequence of the new restrictions could be a shift in focus for Huawei from premium smartphones--once it runs out of critical components for these products--to low- and mid-end smartphones and internet of things (IoT) devices. Huawei can still purchase commoditized chips from companies such as MediaTek Inc. for use in non-premium smartphones, and source components domestically for less-advanced technology hardware products. This shift may accelerate as Huawei exhausts its large inventory of advanced components, which should last six to 12 months.
Changes in Huawei's supply chain and business strategy have implications for Xiaomi's domestic business. Over the past two years, Xiaomi's domestic market share and smartphone shipments have dropped as Huawei ramped up sales in China, and as Xiaomi wound down its inventory of 4G smartphones. At the same time, Xiaomi gained share overseas from Huawei during the second half of 2019, when Huawei's phones began shipping without Android's latest software.
This trend may continue into 2020 and 2021 with Xiaomi gaining overseas market share from Huawei, but losing some share domestically, as Huawei competes more aggressively for sales of domestic low- to mid-end smartphones.
The U.S. restrictions are less likely to affect Huawei's IoT and smart products. Last year, Huawei announced it would begin switching several of its devices to run on its new operating system, HarmonyOS. The switch will likely start with smart televisions and wearables, before moving to more advanced products, such as smartphones and personal computers, in the later stages.
Moreover many IoT and smart products require less advanced chips, which could be manufactured using commoditized chips. This could put pressure on Xiaomi's own IoT products, which have experienced tremendous growth in the past few years. In addition to smartphones, Xiaomi's IoT devices will likely be an important contributor to growth in monthly active users, an important consideration for driving internet service revenues.
Growing Government Support For Domestic Chinese Supply Chains
As Huawei and other domestic technology companies sort through challenges presented by the U.S. restrictions, the Chinese government will likely increase financial and operational support for these firms. Such support measures will likely take several forms, including capital injections, subsidies, tax breaks, expediting regulatory approvals, or cutting red tape.
One such policy directive issued back in 2015, "Made in China 2025," sets to boost the domestic technology sector and reduce dependence on foreign technologies. Another more recent example is the policy directive "3-5-2," which aims to completely remove foreign computer equipment and software from government offices and public institutions in three years (by 30% in 2020, 50% in 2021, and 20% in 2022).
In response, domestic technology companies such as SMIC have increased investment in research and in the commercialization of new technologies. The government has at the same time significantly stepped up subsidies and capital injections into its domestic tech champions, reducing their leverage and increasing their capacity for investment. For instance, SMIC may receive a combined US$9.7 billion from government-backed funds and its fast-tracked listing on the Shanghai Stock Exchange.
Retaliatory Actions Could Be Manageable
The latest restrictions will likely exert a significant hit over the next three to four quarters on our rated foundry companies. Based on our estimates, the new U.S. ruling will affect 15%-20% of TSMC's and SMIC's revenues either directly or indirectly given a reduction in customer orders. The disruption to revenues will likely last three to four quarters. Over the coming 12 months and beyond, strong demand for advanced node chipsets (such as those with seven-nanometer and five-nanometer transistors), should help offset the loss of Huawei orders for TSMC, while a shift of Chinese customers to domestic suppliers should benefit SMIC.
Other companies could experience some indirect effects either because Huawei may shift orders across product segments, or from overseas to China. Some firms may benefit as they fill the vacuum left by Huawei, others may experience a heightened competitive squeeze in China. Xiaomi, Hikvision, and Hon Hai may experience some immediate strains, though we believe the firms will weather the effects. The net effect on Samsung is uncertain as possible increases in orders for 5G base stations and smartphones will offset some orders lost for its memory chip business.
And, while we anticipate some retaliatory measures that could restrict sales of U.S. technology products in China, such measures would only put at risk 2%-5% of the revenue of our rated Asia-Pacific issuers. And that is only for the fairly radical scenario in which U.S. tech companies lost half their sales in China.
Firm-By-Firm Breakdown On Effect Of Expanded Entity List Measures
|Direct Affects Of U.S. Expanded Entity List On Our Rated Asian Tech Issuers|
|Issuer||Rating||Company description||Exposure to USDC Entity List (estimate)||Requires export license under new U.S. ruling?|
Hangzhou Hikvision Digital Technology Co. Ltd.
|A-/Stable/--||Largest provider globally of video surveillance systems and solutions.||Hikvision is on the USDC Entity List. 15%-20% revenues at risk factoring in revenue from premium surveillance gear that use advanced chips||No|
Hon Hai Precision Industry Co. Ltd.
|A-/Stable/--||Largest electronics manufacturing services company worldwide||5%-10% revenues at risk||No|
LG Electronics Inc.
|BBB/Stable/--||Korea-based consumer electronics manufacturer||<5% revenues at risk||No|
Samsung Electronics Co. Ltd.
|AA-/Stable/A-1+||Leading technology company based in Korea with diverse business portfolio||<5% revenues at risk||Mainly foundry business will require license to sell to Huawei|
SK Hynix Inc.
|BBB-/Stable/--||Korea-based memory chip maker||10%-20% revenues at risk||Memory business unlikely to require license to sell to Huawei|
Semiconductor Manufacturing International Corp.
|BBB-/Positive/--||Largest China-headquartered semiconductor foundry.||15%-20% revenues may be positively affected||Yes|
|A-/Stable/A-2||Japan-based company engaged in electronics, entertainment, and financial service businesses||<5% revenues at risk||No|
|A-/Stable/A-2||Japan-based electronic component maker with leading share in lithium polymer batteries for smartphones||5%-10% revenues at risk||No|
Taiwan Semiconductor Manufacturing Co. Ltd.
|AA-/Stable/--||Largest semiconductor foundry worldwide||10%-15% revenues at risk||Yes|
|BBB-/Stable/--||Chinese electronic hardware and internet service provider.||No direct exposure||No|
Hangzhou Hikvision Digital Technology Co. Ltd.
For now, we do not foresee significant rating strain for the company. While the firm relies on chips from HiSilicon Technologies Co. Ltd. (Huawei's integrated circuit design arm) to make its video surveillance products, there are alternative local solutions. Moreover, Hikvision has been building its raw material inventory since the second half of 2019. We believe its inventory levels should be sufficient for at least six months after the restrictions are in place, buying the company some time to manage supplier transitions.
Our base case forecast is for Hikvision's revenue to stay flat in 2020, as declines in sales to government organizations and small and midsized business are offset by revenue from enterprises. Profitability will fall given increasing investments in research and development, especially incremental costs for component substitutions. As a result, EBITDA margins could squeeze to 21%-22% in 2020 from about 25% in 2019. We forecast the free operating cash flows of Chinese renminbi (RMB) 3 billion to RMB3.5 billion for this year, though discretionary cash outflow will likely be RMB3 billion- RMB3.5 billion, on the assumption it pays out about RMB6.5 billion in dividends.
We believe the rating has some buffer even given a worst-case scenario of a 25% revenue decline followed by a recovery, once the company finds supply alternatives. This assumes the absence of revenue from U.S. and Western Europe and for high-end products that may require critical components from HiSilicon or other U.S. suppliers. In this scenario, we estimate that the company's cash flow from operations could reach an outflow of RMB1.0 billion–RMB1.5 billion over the next 12 months. This includes another RMB6.6 billion of working capital outflows for inventory, similar to in 2019. Even in such a scenario, the company should still have plenty of headroom given its net cash position of about RMB12.7 billion as of June 30, 2020, even if the company continues to pay dividends of RMB6.5 billion per annum.
Hon Hai Precision Industry Co. Ltd.
We do not foresee any immediate rating hit for the Taiwan-based electronics manufacturer, despite dimmer business prospects if Apple Inc. and Huawei, two of its major customers, experience significant business headwinds simultaneously. We estimate that revenues and EBITDA from Huawei accounted for only a single-digit percentage of Hon Hai's total, and the dispute won't likely cause a material deterioration in Apple's global iPhone sales from our baseline assumptions.
In addition, Hon Hai has maintained a net cash position and working capital inflows from slowing revenue will likely support a strong free operating cash flow and a sound balance sheet, despite materially weaker EBITDA in 2020. Apple accounts for about half of Hon Hai's revenue.
Tightened restrictions may add to Hon Hai's COVID-19-related operational strains, hindering its recovery over the next 12 months. Global disruptions stemming from the pandemic have contributed to a 6.7% drop in Hon Hai's revenue (year on year) in the first half of 2020. Its recovery remains shaky as the pandemic effects play out.
Samsung Electronics Co. Ltd.
Restrictions on Huawei will likely have a mixed effect on Samsung. Samsung competes with Huawei in the smartphone and network equipment markets. Additional restrictive measures imposed by the U.S. on Huawei and the ban on its 5G network equipment by several other countries can benefit Samsung. The latter can use the opportunity to substantially strengthen its telecom network equipment market position over the next two to three years. Additionally, Huawei's loss of its Android license, and the new restrictions on sourcing chips from foreign manufacturers could help Samsung, particularly if Huawei loses out on sales of 5G smartphones in developed markets.
However, Huawei is also a major buyer of Samsung smartphone components, including memory semiconductors, display panels, and camera modules. Lower Huawei handset sales could weaken demand for these components, and Samsung may find it difficult to fully replace the lost revenue with sales to other customers, at least in the near term.
SK Hynix Inc.
Hynix will likely perform well in 2020 despite its heavy exposure to USDC Entity List companies such as Huawei. This is mainly attributable to strong demand for server DRAM and solid-state drives amid rising investment in data centers. Hynix's memory chip operations are also not subject to U.S. restrictions.
Weaker demand for smartphones amid a global COVID-induced recession may weigh on the firm's mobile DRAM segment. Nonetheless, the company's robust market position in the oligopolistic global memory chip market should let it keep its financial metrics at a level commensurate with the current rating, in our view.
Semiconductor Manufacturing International Corp.
We estimate that companies on the USDC Entity List directly and indirectly contribute about 15%-20% of SMIC's revenue. Should the latest U.S. restrictions affect SMIC, its revenue will likely grow 16%-20% in 2020, but to be about flat in 2021. Strong domestic demand--driven by favorable government policies, and domestic companies looking to reduce reliance on U.S. suppliers--will likely offset some of the revenue loss.
As tension between the U.S. and China continues to rise, the Chinese government will likely provide administrative and business-related policies promoting the purchase of domestic products and technologies supporting demand growth for SMIC's manufacturing services. This should result in higher capacity utilization for its advanced node processes, such as its 14 nanometer process node, which entered mass production in the fourth quarter of 2019.
In addition to favorable government policies, SMIC will likely receive financial support, such as capital injections and preferential taxes and subsidies for research, all aimed at narrow its technology gap with industry leaders such as Taiwan Semiconductor Manufacturing Co. Ltd. and Samsung. Already, the company's fast-tracked listing on the Shanghai Stock Exchange is set to raise up to US$7.5 billion. The sum, combined with US$2.25 billion received from two government-backed funds targeting domestic semiconductor firms will help it raise US$9.7 billion in 2020.
As a result, we now believe SMIC's chances of successfully developing and commercializing advanced technologies have increased, resulting in our revision of the company's outlook to positive for our 'BBB-' issuer credit rating (see "SMIC Outlook Revised To Positive On Increasing Financial Resources And Government Support; 'BBB-' Rating Affirmed," July 13, 2020).
For now, such supportive measures from the government for SMIC won't likely translate into extraordinary government support in a distress scenario. This is because most of the government's financial support has been provided to SMIC's subsidiaries directly involved in the development of advanced technologies.
We do, however, consider support measures--including government subsidies and capital injections--in our calculation of the company's adjusted EBITDA and net debt. In addition, we assess the comparable rating analysis on SMIC as positive, reflecting other qualitative government support measures.
As a global leader of batteries for devices such as smartphones and earphones, we believe TDK will be able to shift orders from Huawei to other customers. This is because we believe polymer-based technology is an essential part of smartphones. Based on these assumptions we assume TDK can absorb the COVID-related hit to its earnings within the current rating tolerance.
TDK's revenue will likely decrease 5%-10% in 2020, largely due to slower sales for passive components globally. We believe the profitability will slightly decrease in 2020, but it is likely to gradually recover because of its strong competitiveness and the solid performance of its existing businesses, including batteries.
Taiwan Semiconductor Manufacturing Co. Ltd.
The tightened restrictions on Huawei are unlikely to move the ratings on TSMC, despite the company's significant revenue from Huawei. TSMC has seen strong demand for its high-performance computing chips for servers, personal computers, and communications gear. Emergency investment in data centers and communications infrastructure, together with mass production using five-nanometer process technology, and Chinese companies' chip inventory buildup in response to the U.S. sanctions have boosted TSMC's revenue by about one-third (year on year) in the first half of 2020.
The company's revenue growth will likely slow over the next three to four quarters when demand related to working-from-home measures drops off, and sales to Huawei end. TSMC has guided the market to expect strong growth during the third quarter of 2020, as demand for 5G devices offset declining smartphone shipments and some of the negative effect of the new Huawei restrictions. These measures takes effect in September, and will affect less than a third of TSMC's revenues during the quarter. However, fourth quarter sales will likely decline year-on-year given the full effects of the new restrictions and slowing end-demand.
TSMC's leadership in advanced technology, particularly for five-nanometer and seven-nanometer processes, may help the company secure steady revenue and earnings growth. Its clients use TSMC manufactured chips in premium smartphones, 5G mobile communications, and high performance computing. Even if the firm fails to secure a waiver from the U.S. government to supply Huawei, it has a wide client base to draw on.
The rating on Xiaomi will likely remain stable. However, we view the company's internet services business (excluding financial services) as a core profit driver and source of recurring revenue for the company. Any inability to grow this segment due to a loss of domestic market share for smartphones or internet-of-things (IoT) devices, may strain our rating on the firm.
Xiaomi will likely face challenges for its domestic smartphone sales in the coming four to six quarters. Huawei may price its 5G handsets aggressively to offset lost revenues overseas. Over the next two-three years, Huawei may switch focus to mid-end models once its inventory of key components are exhausted, weighing on Xiaomi's low- and mid-end smartphone pricing and sales volume. At the same time, we anticipate Xiaomi will continue to gain share in overseas markets from Huawei, as the latter continues to be affected by U.S. restrictions.
IoT revenues could be less affected given the strong demand growth in this segment. Huawei will likely step up competition in this segment as well. However, we believe Xiaomi's revenue and profitability will remain largely unchanged from our current base case, as the company capitalizes on its strong market presence to grow the segment.
Xiaomi's revenue will likely grow 3%-7% in 2020, down from 17.7% in 2019. This decline will largely reflect the effects of COVID-19 on smartphone sales globally, and intensified competition. Revenue growth should recover in 2021 to about 16%-20% spurred by strong growth in 5G smartphones, IoT, and internet financial services revenue.
- SMIC Outlook Revised To Positive On Increasing Financial Resources And Government Support; 'BBB-' Rating Affirmed, July 13, 2020
- A Slow Recovery And U.S.-China Trade Tensions Could Test U.S. Investment-Grade Tech Companies, June 8, 2020.
- As Global IT Spending Falls, Tech Ratings Pressure Rises, April 29, 2020.
- Bans On Huawei Will Hit Tech Harder Than Telecom, But Not Enough To Move The Ratings, June 21, 2019
This report does not constitute a rating action.
|Primary Credit Analysts:||Clifford Kurz, Hong Kong (852) 2533-3534;|
|Raymond Hsu, CFA, Taipei (8862) 8722-5827;|
|Secondary Contacts:||JunHong Park, Hong Kong (852) 2533-3538;|
|Hins Li, Hong Kong (852) 2533-3587;|
|Cher Chen, Hong Kong (852) 2533-3569;|
|Kei Ishikawa, Tokyo (81) 3-4550-8769;|
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