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Global Tech's Shift From China: The Effects By Firm


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Global Tech's Shift From China: The Effects By Firm

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Global tech is investing heavily to reduce its reliance on China. Deepening geopolitical strains, controls on tech exports to China, and supply outages during the pandemic have prompted companies to diversify production. S&P Global Ratings believes the transition will be modestly credit negative for the global tech firms we rate for three to five years.

Dispersed manufacturing won't be as efficient as utilizing giant factories in China, which maximize economies of scale and draw on established supplier networks, infrastructure, and talent. Some companies may retain redundant capacity in China in case they encounter production hiccups while ramping up new sites.

Firms are managing push and pull factors. The U.S., Japan, and the EU are offering substantial incentives to firms to relocate some capacity in their respective markets. On the flip side, many firms are threatened by the escalating trade hurdles that the U.S. imposed on tech exports to China. Companies with high revenue exposure in China must carefully plan any reduction production there, or risk losing goodwill among Chinese consumers.

We believe that most of tech firms under our rating portfolio have financial resources and managerial expertise to manage their supply-chain recalibration, within current ratings.

Successful execution should strengthen firms' supply chain and operating resilience against disruptive events. This may include abrupt, country-specific events or shifts in the business or regulatory climate.

We break down the likely impact on a range of large tech firms that we rate.

Which Firms Are Affected, And How

Taiwan Semiconductor Manufacturing Co. Ltd. (TSMC; AA-/Stable/--)

The world's biggest contract chip maker has most of its plants in Taiwan, and most of its sales are to U.S. firms. This forms a large incentive to diversify and, indeed, it is building a US$40 billion fab in Arizona. In so doing TSMC is taking advantage of American subsidies.

There will be a margin hit. U.S. engineers earn about 2x-2.5x more than their peers in Taiwan, operating expenses will be about 40% higher in Arizona than for a comparable facility in Taiwan, and depreciation costs are 1.3x-1.4x higher in the U.S. than in Taiwan, by our estimates (see "Global Tech's Moves From China Will Be Costly…And Unavoidable," published April 20, 2023, on RatingsDirect).

Accordingly, we believe TSMC will slowly build a greater share of its new capacity outside of Greater China. Its planned expansion to the U.S., Japan, the EU, and mainland China is unlikely to materially lower its asset concentration risk over the next two years.

The company still expects to focus most of its investment in Taiwan, particularly for its most advanced technology. This includes the production of 3 nanometer (nm) and 2nm semiconductors. This is to leverage its strong research and supply chains in Taiwan, as well as to meet the Taiwanese government's requirement of keeping the most advanced process technology production in TSMC's home market.

TSMC's moves abroad will help it manage the limited water, power, and talent in Taiwan. The country is also prone to earthquakes, a problem for TSMC's highly calibrated machines.

Diversification abroad would also win goodwill among major governments, which want to expand local chipmaking. Many countries see this as a matter of economic security.

Taiwan will likely remain TSMC's main production site to make the most advanced process nodes. But we expect the company to increase its cross-border presence into sites that use slightly trailing technology.

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Apple Inc. (AA+/Stable/A-1+)

Apple Inc.'s dealings with China are vast and not easily unwound. The country makes about 95% of the firm's iPhones and about 20% of Apple sales are within Greater China. Nevertheless, we assume the firm will slowly expand production of iPhones, Apple Watches, and AirPods in India, Vietnam, and Indonesia.

We see less of a flight from China but more of an embrace of other markets. Labor in Vietnam, India, and Indonesia is now cheaper than in China. The Indian government has become more open to letting Apple build and sell goods in that country. These markets have also become more important to the company's sales growth, perhaps more so than the increasingly saturated Chinese market.

In moving some production to other countries, Apple is adding needed diversification, and addressing concentration risk.

For example, in November 2022, Chinese COVID measures largely shut down the Foxconn plant that makes the iPhone 14. The shutdown was in Zhengzhou, also known as "iPhone city", and it was accompanied by worker protests. This resulted in delayed shipments and lost sales for Apple.

While the Zhengzhou incident was short-lived and China has since ended all its pandemic controls, it was a reminder to Apple about the upside of diversification. We assume that India's share of iPhone production will double by 2025, for example, albeit from a low base. Samsung's experience in moving smartphone production from China to Vietnam shows it can be done, without sacrificing quality or capacity.

Nevertheless, Apple will continue to rely heavily on China as a supply-chain hub, in our view. Any expansion of ex-China production will largely be about servicing rising sales in important new markets, such as emerging Asia.

Apple continues to gain share in China PC and smartphone markets. This trend should continue in 2023. Any desire to shift its assembly and manufacturing capacity away from China will have to be balanced with China's growing customer base and their preference for "buying local."

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Hon Hai Precision Industry Co. Ltd. (A-/Stable/--)

As the dominant maker of iPhones for client Apple Inc., Hon Hai has a deep presence in mainland China. It employs about 900,000 staff during its peak production season, of which most are based in mainland China.

That said, the world's largest electronics manufacturing services (EMS) firm is operating with a different calculus when considering reduced reliance on mainland-based production.

EMS entities work with tight margins. Labor costs are important. The upshot is that EMS firms moving capacity out of mainland China to manage rising labor costs in the market and to add resilience to their supply chains. The clients of EMS firms are also asking for more production diversification. This is different to what is happening to the chip firms, which are expanding capacity outside of China largely in response to government pressure.

Hon Hai can assemble most of its networking and communications products outside of mainland China, such as in Taiwan and Mexico. We believe Hon Hai will gradually boost its production in Vietnam and India for smartphones and PCs as the governments raise their infrastructure spending.

Hon Hai is also aggressively building its electric vehicle (EV) business. This creates growth, particularly as the smartphone market matures.

We believe Hon Hai's EV line presents opportunities to build capacity outside of the mainland, given most of its EV-related investments and projects are outside Greater China. The company has major projects underway in the U.S., Mexico, Thailand, and India, and will gradually increase its presence in Europe and other Asian countries.

Rising costs stemming from less efficient supply chain management and weaker economies of scale will squeeze Hon Hai's margins at its new production sites for the next one to three years. However, the profit trend will be positive over the coming five to 10 years, in our view, as the firm ramps up operations with lower staff costs, and new sites reach full scale.

Hon Hai's strong profitability and cash-flow generation will support its rising capex and investment needs. This should keep the company debt-free on an adjusted basis, even as it spends heavily on geographic diversification and EV business development over the next two to three years.

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Semiconductor Manufacturing International Corp. (BBB-/Negative/--)

Our negative ratings outlook on SMIC reflects incremental operational and supply-chain risks arising from U.S. export restrictions, enacted in October 2022.

SMIC could be hurt by the coming shifts to the global semiconductor supply chain and restriction to advanced semiconductor capital equipment due to the U.S. export ban. Its overseas customers, which accounted for almost one-third of its revenue, may move orders earmarked for ex-China markets to offshore foundries.

Domestic orders may not be immediately strong enough to fully compensate for the reduced overseas demand. The Chinese customers that typically buy large quantities of chips are grappling with weak consumer sentiment.

Specifically, consumer demand could remain soft for electronics and smart-home items over the next few quarters. Those product segments accounted for about two-thirds of SMIC's revenue.

SMIC's capacity utilization will fall to around 80% in the next two years, in our view, from 92% in 2022. This would pull its EBITDA margin down to 46%-49% in the forecast period, from 57%-59% in 2022.

The decline may squeeze SMIC's revenue growth and capacity utilization as it continues to invest in new capacity over the next one to two years.

Broadly, SMIC should benefit from the Chinese government's push for semiconductor self-sufficiency and digitalization. Both factors should fuel domestic demand for SMIC. The government will continue to back the company with sizable government subsidies, helping capex and research costs.

Samsung Electronics Co. Ltd. (AA-/Stable/A-1+)

Korea-based Samsung Electronics is exposed to the China diversification trend. While it has already moved all its smartphone manufacturing out of China, it retains significant chipmaking facilities in China.

U.S. controls on the sale of high-tech goods to China have put a cloud over Samsung's chip operations in China. The company risks losing access to the equipment it needs to upgrade plants, to ensure they stay competitive.

The U.S. has granted Samsung a one-year waiver on these controls. Our base case is that the waiver will be renewed for years to come. However, this uncertainty is not ideal for a sector that relies on heavy investment and years of forward planning.

We assume Samsung, as such, will gradually move production out of China. The firm has already pledged to expand production in the U.S. (Texas) and Korea (Yongin) over the next five to 10 years.

Moving out of China will add costs and may result in lost sales for the firm. A good portion of its customers are in China, particularly in the PC and smartphone segments. Having a production base within China helps reduce transport and logistics costs. Moreover, chips made outside of China could be subject to tariffs when brought into the country.

Samsung's experiences in its consumer electronics units offer some clues about what's ahead for its chips division. Samsung began moving production away from China in 2018, during a time of heightened geopolitical tension. The company closed its telecom equipment plant in Shenzhen that year. It subsequently closed smartphone plants in Tianjin (2018) and Huizhou (2019), and PC manufacturing in Suzhou (2020).

The moves were correlated with lost sales. Samsung's share of China's smartphone market fell to under 1% in 2022, from over 13% in 2014, for example.

SK Hynix Inc. (BBB-/Negative/--)

Korea's SK Hynix is in a delicate spot. The firm is contending with a steep cyclical downturn for its core memory-chip product. We have a negative outlook on the rating, putting it a risk of falling below investment grade.

In this context, its China situation has taken on extra importance. SK Hynix has about one-third of its memory-chip production capacity in China, with around half of its DRAM capacity in the country and one-quarter of its NAND capacity.

Like Samsung, its Chinese facilities are now facing U.S. restrictions on the import of sensitive technology equipment. Unlike Samsung, SK Hynix is a pure memory-chip firm. It cannot fall back on other businesses to fund a wholesale move out of China, building fabs elsewhere while quietly running down its Chinese operations.

SK Hynix benefits from the same waiver on U.S. controls on semiconductor equipment exports to China. As with Samsung, the waiver is renewed annually, and our base case is that this will carry on for years. An inability to upgrade production facilities due to restrictions on equipment imports into China could hit SK Hynix's competitiveness.

While SK Hynix does have a contingency plan of adding capacity in Korea in the case that the waiver is not renewed, the plan requires tens of billions of dollars of investment and several years to implement.

The company plans to add capacity to plants in Chongju and Yongin to address its China risk. However, this is four to five years away, which makes its unlikely for SK Hynix to shift material production to Korea anytime soon.

Dell Technologies Inc. (BBB/Stable/--)

Dell's revenue from China is small, at around a mid-single digit percent, but it has a significant manufacturing footprint in China. Soon after the U.S. announced strict export controls on China in October 2022, the company said it aimed to stop using semiconductors made in China by 2024.

The ban includes chips produced at facilities owned by non-mainland Chinese semiconductor manufacturers.

We view this announcement as material. It indicates that Dell is aggressively looking to diversify its supplier and manufacturing relationship beyond China.

We expect Dell to maintain most of its manufacturing footprint in China while it invests in other manufacturing hubs in Southeast Asia, Latin America, and elsewhere. We think this transition will take up to a decade.

It will be difficult for the firm to replicate the intricate ecosystem of suppliers and contractors Dell has developed in China. The diversification of its supply chains will likely squeeze its already-thin operating margin, but we assume a broadening of the firm's sourcing and manufacturing will eventually be a credit positive.

Politicians will frame the Chips Act and bans on semiconductor exports as protecting national security interest. For example, the tens of billions committed to subsidies to build chip plants in Japan, the U.S., and the EU are about managing a heavy dependence on semiconductor supply from Greater China, a region of escalating geopolitical tensions and uncertainties.

Companies are thinking about their credit metrics and their duty to shareholders. They are highly reluctant, for example, to put their China sales at risk with a high-profile announcement or an abrut move to diversify production from the country. They will instead quietly add capacity in other nations to make production more resilient in a crisis. Countries are rethinking globalization; companies, we assume, are just reworking supply chains.

This report is the second of a two-part series examining moves by global tech to diversify production away from China. The first report, which looked at the factors underpinning this trend, is titled, "Global Tech's Moves From China Will Be Costly…And Unavoidable."

Writing: Jasper Moiseiwitsch

Digital design: Evy Cheung

Related Research

This report does not constitute a rating action.

Primary Credit Analysts:HINS LI, Hong Kong + 852 2533 3587;
David L Hsu, Taipei +886-2-2175-6828;
Secondary Contacts:David T Tsui, CFA, CPA, San Francisco + 1 415-371-5063;
Andrew Chang, San Francisco + 1 (415) 371 5043;
Ji Cheong, Hong Kong +852 25333505;
Kei Ishikawa, Tokyo + 81 3 4550 8769;

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