For a minute, Sharp was saved.
The 100-year-old maker of LCD screens was once a consumer electronics powerhouse but has stumbled in the face of fierce price competition and ill-advised investments in advanced production plants. Earlier this month, Sharp reported a net loss of $208 million for for its fiscal Q3, bringing the nine month loss to nearly a billion as the company continues to lose market share to Samsung, LG, and other Asian competitors.
Foxconn founder Terry Gou sees Sharp’s dire straits as an opportunity for Hon Hai Precision to solidify its position and pricing power with Apple, which is seen adopting OLED screens for iPhones by 2018. Sharp hopes to become a global OLED supplier.
“The OLED sector is virtually a monopoly right now,” Lisa Li, vice president of Sigma Intell says, referencing Samsung’s iron grip on the space. “This must be something Apple is pretty concerned about.”
“An iPhone’s most expensive component is its touch screen display, making up more than 20% of manufacturing costs, which is why Mr. Gou is eager to supply them,” WSJ writes. “Sharp is one of three suppliers of iPhone screens.”
"It’s widely understood that Hon Hai wants to consolidate Sharp in order to secure its dominant position in Apple’s supply chain; the combined group could provide EMS services as well as displays, touch panels, camera modules, metal casings, FPCBs and connectors," BNP remarked, in a note out last week.
Gou has had his eyes on Sharp since 2012, when a deal for Foxconn to take a 10% stake fell apart due in part to Sharp’s abysmal operating performance.
Foxconn’s latest overture would have seen Sharp issue shares worth something like $4.3 billion which Hon Hai would buy, giving the Taiwanese contract manufacturer a 66% stake in the Japanese company. As Bloomberg notes, “Foxconn would also put down a 100 billion yen deposit that Sharp can keep if the sale, which is contingent on shareholder approval, doesn’t go through.”
There were already all kinds of questions swirling around about whether Foxconn was thinking too much about Apple and too little about how it planned to turn around the loss-making machine that Sharp has become. Now, it looks like Hon Hai may have gotten cold feet after realizing what bad shape the Japanese company is actually in.
Just hours after Sharp’s board agreed to a takeover - which WSJ notes marked something of a coup as “Japan has been reluctant to let a major domestic company go into foreign hands, and many people had argued that the 103-year-old Sharp should go to a Japanese buyer” - Foxconn put the deal on ice by releasing the following rather amusing statement:
We acknowledge receipt of a notice today from Sharp’s Board choosing us as their preferred partner. After receiving new material information from Sharp yesterday morning, we have accordingly informed Sharp last night [before their board meeting on 2/25] that we will have to postpone any signing of a Definitive Agreement until we have arrived at a satisfactory understanding and resolution of the situation.
Yes, Hon Hai needs to “arrive at a satisfactory understanding of new material information,” which, according to sources means Foxconn got a look at Sharp’s contingent liabilities and didn’t like what it saw.
Specifically, Sharp sent over a 100-item list that adds up to ¥350 billion, just “slightly” more than the ¥17.2 billion in such items spelled out in the company’s 2015 annual report. As WSJ goes on to detail, the list includes everything from costs tied to buying raw materials for solar cells to EU antitrust litigation to North American civil suits.
If that sounds like a lot of potential headaches to you, you’re apparently on the same page as Gou. Sharp had no immediate comment.
Foxconn reportedly hopes to clear the matter up as soon as possible, but perhaps shareholders should hope they don't. Sharp said today it was looking to allocate some of the funds from Foxconn's investment to things like robots and "auto-related cameras." How Foxconn intends to run this company while simultaneously operating its own business is still largely a mystery. "Foxconn doesn’t have any experience in any of Sharp’s businesses," Jefferies analyst Atul Goyal says. "In fact, it creates large conflicts of interest with this acquisition."
Of course the biggest "conflict of interest" here may be the "conflict" that occurs when you merge an unprofitable company with a profitable one and that may indeed be part of the reason why Foxconn is thinking twice.
We close with a bit more commentary from BNP (who just downgraded Hon Hai) on the proposed deal.
From BNP
There’s a historical context involved here. In 2012, Hon Hai first offered to invest in Sharp but the talks stumbled after the Sharp management’s fear of losing IP control as well as the concerns over leakage of key technology outside of Japan. Hon Hai has been widely regarded as a company that has focused on vertical integration in supply chain and aggressive in expanding its business beyond the assembly of consumer electronics products, by adding a wider bunch of components to its services. Hence, the market‘s view is largely that by acquiring Sharp, one of the world’s leading players of displays in electronics components, Hon Hai could gain more business from Apple and other customers including some Chinese companies. In our view, Hon Hai is targeting Sharp’s IP and advanced technologies in both small and large size display (LTPS and IGZO), which will likely further enhance Hon Hai’s competitive advantage and bargaining power. Yet, the market is currently speculating that Apple is likely to adopt AMOLED in future product, compared to its Korean peers-Samsung and LGD, Sharp’s AMOLED development is much slower. We concerned about Sharp’s position in Apple’s display supply chain in this increasingly tough competitive environment for small LCDs. Aside from panel, Sharp is currently a major supplier for Apple’s camera module. However, we are witnessing competition from Sony, Cowell or even ASE continues to rise. Additionally, we think there is limited upside for Hon Hai to further gain shares in Apple’s camera module business.
It would take time for Hon Hai to turn Sharp around and the restructuring process may be challenging, in our view. Hon Hai currently trade at c9x of our 2016 EPS estimate and c1x 2016 PBR. We foresee no share price upside catalyst in the following months due to its muted sales outlook and uncertainties around the proposed Sharp deal. We also think its 5% dividend yield may not be sustainable due to its aggressive M&A strategy. We view the porposed transaction will take time to monetize the potential synergies while the Sharp deal appears to be counter-intuitive to Hon Hai’s financial position and financial performance in short-to-mid-term. Given our earnings cuts on muted demand outlook and potential risk on Sharp deal, we downgrade Hon Hai to Hold from Buy with a new TP of TWD74 (from TWD92), based on 8.5x PE, the historical mid-to-low end range (down from 10x PE, the historical mid-range) as the uncertainties around the Sharp deal will likely drive a de-rating of the stock, in our view.