The technology sector was consumed by the U.S.-China trade war over the past two years. The signing of the Phase One trade agreement on Jan. 15, 2020, between the two largest economies in the world certainly provided a sigh of relief. We forecast in November 2019 that smartphone, server, and semiconductor markets would return to growth in 2020 following a year of disappointing sales.

However, that now hangs in the balance as the unexpected and rapidly spreading coronavirus outbreak that originated in Wuhan, in China's Hubei province, became an international health concern in January 2020, threatening to paralyze the world's most important technology manufacturing hub.

China has led manufacturing of electronics for decades because of low-cost and skilled labor. The tech supply chain is optimized by strategically clustering manufacturing facilities such that delivery time from parts suppliers to manufacturing facilities is minimized and production flexibility (i.e., changed orders) meets customers' demand. This is important as hundreds of parts go into the production of smartphones, servers, notebooks, etc., from different parts of the world. While tech companies benefit from the low cost and time-to-market efficiencies of this complex setup, its drawbacks are magnified by exogenous shocks such as the coronavirus outbreak.

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Since Jan. 23, 2020, Chinese state and local governments, in an attempt to control the spread of the virus, shut down Wuhan and many other Chinese cities under quarantine orders, affecting over 60 million people. Public transportation, trucks, couriers, rail, ships, and flights were halted. Manufacturing facilities remained closed beyond the Lunar New Year holidays.

Some companies were expected to resume manufacturing operations beginning Feb. 10--including Hon Hai Precision Industry Co. Ltd., Apple Inc.'s major iPhone and iPad supplier. Nevertheless, resumption of production is expected to be slow as it's unclear how many factory workers who live in cities miles from the factories can and will return to work given limited travel options and the continuing threat of the contagious coronavirus. Even if manufacturing facilities resume production, it's unclear when shipments can be flown to customers.

S&P Global Ratings' economics and research team currently estimate that the virus could lower China's GDP growth by 70 basis points (bps), to 5% this year, with a peak effect in the first quarter before a rebound begins in the third quarter, and lost output largely recovered by end of 2021. In turn, it would trim 30 bps from global GDP growth this year. Our baseline assumption is that the coronavirus crisis will stabilize globally in March 2020, with virtually no new transmissions in April (see "Coronavirus Casts Shadow Over Credit Outlook," Feb. 11, 2020). However, if the disease is not brought under control in March, the economic impact could be much larger. At this point, we haven't taken any rating actions on tech companies related to the coronavirus outbreak. We assume the impact to the global tech sector will be temporary and that near-term activity losses can be made up later.

For most tech products that don't exclusively rely on China for manufacturing and assembly, we expect tech companies to increase production activities elsewhere to make up for lost volume in China, or to identify alternate suppliers for key parts. While suboptimal, it is a quick remedy for a temporary disruption. More important, we expect most tech companies to be resilient and resourceful, seeking alternative suppliers and minimizing production disruptions and associated economic impact, much as they did when faced with potentially higher costs from tariffs and the ban on sale to Huawei Technologies Co. Ltd. over the past two years.

While some tech companies' business results and financial metrics may temporarily weaken from the supply chain disruption, we expect limited rating pressure as of now. So far, companies have maintained a cautious tone during earnings calls with wider revenue guidance for the subsequent quarter given the lack of clarity on the length and magnitude of the current disruption. For now, we largely expect reduced demand or supply chain disruption to reverse over time and limited rating pressure. If the outbreak is quickly contained, we do not see a risk of major disruption to the tech supply chain. We would expect affected tech companies to speed up production in the second half of 2020 to recoup lost revenues as enterprises and consumers catch up on delayed spending. We estimate that China accounts for more than 20% of global IT consumption.

Most tech companies we rate have stable rating outlooks, and their credit profiles also have cushion to tolerate a moderate decline in sales volumes. However, smaller companies with high geographical or product concentration in China would be more vulnerable even to short-term demand or supply disruptions if cash flow is impaired, given their generally weaker liquidity positions. In our view, higher credit risk would come from prolonged supply chain disruptions, which could lead to significant demand reductions, significant cash flow impact, or liquidity concerns.

How Coronavirus Will Affect Asia-Pacific

A temporary disruption in China's hardware supply chain is inevitable for the virus outbreak, even though most companies were to resume operations in most parts of China during the Feb. 10 week after the extended Lunar New Year break. Transportation restrictions and heightened quarantine measures countrywide could post challenges securing sufficient labor and material supply for hardware companies and limit production initially, although the epicenter of the outbreak, Hubei is not a major production hub. The impact of the epidemic on hardware companies in Asia varies, which depends on their exposure to the hardware supply chain and end markets in China, as well as their labor intensity.

EMS and electronics component companies such as Hon Hai are most exposed to labor and logistics challenges during the outbreak. It depends on external component and material supply for enormous facilities that employ hundreds of thousands of assembly line workers. Some of Hon Hai's facilities received approvals to restart on Feb. 10, but we believe it is unlikely to resume full production over the next 2-3 weeks at the earliest. It remains unclear how soon the company can return to normal operations, given the shortage in labor and protection gear.

Disruption for some Chinese tech companies, particularly in the semiconductor sector, could be less. Semiconductor Manufacturing International Corp. and fabrication plants for Taiwan Semiconductor Manufacturing Co. Ltd. (TSMC), Samsung Electronics Co. Ltd., and SK Hynix Inc. all report no disruption so far. However, bottlenecks throughout the supply chain will inevitably affect near-term shipments and revenue, in our view.

The first half of the year is typically the low season of the production cycle for most information technology devices, and this could partly alleviate underutilization for a brief time. The China government is also likely to actively assist key industries, including the tech sector, in maintaining normal operations and minimizing economic impact. Hon Hai as China's largest exporter is likely to benefit. In addition, we believe the short-term revenue and cash flow shortfall are unlikely to significantly diminish the leverage and liquidity buffer for the ratings on Hon Hai and Chinese hardware companies under our baseline assumptions.

Generally lower dependence on production facilities in China could help rated Korean and Japanese tech companies better manage production during the outbreak, in our view. Those companies have built significant capacity particularly in Southeast Asia to diversify their production footprints over the past few years. Nonetheless, revenue for Sharp Corp., TDK Corp., and SK Hynix could still drop significantly with a prolonged disruption because they generate more than 30% of their revenues from China. TSMC, Samsung, and Renesas Electronics Corp. could also lose revenues moderately, with more than 10% generated from China. Those companies mainly supply many key components including semiconductors, display panels, and batteries for final assembly in China.

We believe rating pressures on these companies are largely limited because the potential revenue and cash flow shortfall is unlikely to materially alter their financial positions based on current cash flow and leverage buffers. Nonetheless, ratings on weaker companies with low rating headroom, such as Sharp, could be more pressured if the outbreak persists longer than we expect and lead to a sustained decline in cash flow. Sharp's ratio of debt to EBITDA could deteriorate to above 5.5x, the level to sustain the current ratings, if revenue declines 10% annually.

How Coronavirus Will Affect North America

Tech original equipment manufacturers (OEMs), electronic manufacturing service (EMS) providers/contract manufacturers, parts and subassembly makers, and semiconductor firms will feel the impact of the coronavirus outbreak to varying degrees. We discuss here how each segment could be affected and our view on potential rating impact:

Smartphones

Apple, relative to other hardware OEMs, has been reluctant to diversify its manufacturing and assembly base away from China. We believe it wants closer ties to the world's most populous nation for product sales (China, Taiwan, and Hong Kong represent about 20% of Apple's total revenue) and to reap the benefit of a manufacturing cluster that allows better economics and flexibility in design changes.

To be sure, this strategic positioning comes with risk of supply chain being overly reliant on China. Now, Apple and its contract manufacturers have to contend with factory closures, or underutilizations if reopened, as certain local governments continue to uphold their quarantine orders. Migrant workers might not be able or willing to return to the factory floors. Transportation and logistics are also disrupted as routes for couriers, trucks, rail, ships, and flights might not return to normal for an extended period.

So far, Apple on its earnings call on Jan. 23 widened its revenue guidance to reflect the uncertainty around the coronavirus impact. Apple and its largest supplier, Hon Hai, said production would resume after a 10-day delay on Feb. 10. Apple also announced that most of its retail stores in China would be closed through Feb. 15 out of caution. While iPhone demand would temporarily slow, we believe customers are generally more loyal to Apple than other Chinese OEMs and expect demand will recover in subsequent months. On the supply side, we believe iPhone retail and factory inventory should be sufficient to alleviate short term production delays. Even if quarantine orders are lifted, we suspect it will take time for foot traffic to return. While Apple's track record of navigating supply chain challenges leads us to believe the coronavirus will not permanently impair its business, we expect underutilization of facilities and disruption of parts and components shipments to assembly plants would temporarily lower sales that would be recaptured over time.

We would not be surprised if this leads to near-term order cuts, which would have a cascading effect to its supply chain downstream (contract manufacturers and parts and components suppliers). However, we do not expect this will affect Apple's major product release this fall. Over the longer term, having suffered through the trade spat and now coronavirus, we suspect that Apple will seek to gradually diversify its manufacturing base away from China even at the risk of reducing profitability.

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Notebooks and servers

We believe the recent U.S.-China trade spat prompted notebook OEMs (and their contract manufacturers such as Quanta Computer Inc., Inventec Corp., Compal Electronics Inc., Pegatron Corp., and Wistron Corp.) to consider relocating manufacturing and assembly capacity from China to countries such as Taiwan, Vietnam, the Philippines, and Indonesia. However, we do not believe this has taken place quick enough for notebook OEMs such as Dell Technologies Inc. and HP Inc. to absolve them from potential supply chain disruptions from the outbreak.

Similar to Apple's iPhone, global manufacturing and assembly of notebooks are highly concentrated in China. Given continued strong demand for commercial notebooks as a result of the Windows 10 refresh cycle, we expect notebook OEMs' sales will slow if the production disruption lingers, with Dell feeling the effects sooner than others given its just-in-time production model. Still, we believe sales would be merely delayed, rather than lost.

The servers supply chain depends less on China compared to notebooks. We believe most server motherboards are prepared in Taiwan, and finally assembly is done in Mexico, the Czech Republic, and China for sales in their respective regions. While server pricing could be affected given potential demand-supply dynamics of input costs, such as memory and other semiconductor components, we do not expect this to hit supply chain members.

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EMS/distributors/components

North American firms have relatively high exposure to tech supply chain disruptions. EMS providers tend to have a high proportion of their revenue, at 20%-25%, from China and rely on a fully functioning transportation and logistics system to ensure parts are delivered on time and finished goods can be shipped to customers. Jabil's revenue from China is even higher, estimated at 40%-50%, because of Apple exposure. While shifting certain manufacturing activities outside of China could be an option, the time and added costs could prove prohibitive. It is unclear how long local quarantines will continue and when public transportation will return to normal.

We expect the coronavirus outbreak to have a meaningful impact on TTM's business. TTM is a PCB manufacturer. The company's first-quarter revenue guidance is down mid-single-digit percentages year-over-year. If factory shutdowns extend beyond Feb. 10, its financial results will be impaired further. Also, the estimated impact doesn't consider if TTM's customers are down for longer or have different supply chain issues (as the guidance contemplates only direct impact on the company). From a ratings perspective, TTM's recently announced plans to divest its mobility business and reduce its manufacturing footprint in China could be a compensating factor if proceeds will be used for debt repayment.

Our rating outlooks on most of these issuers are stable. However, if production suspension is protracted and liquidity becomes strained, it could result in negative rating actions on some of these issuers.

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Semiconductors

China consumes 40%-50% of global semiconductor output, for both domestic consumption and assembly bound for export. As a result, U.S. semiconductor firms have high revenue exposure to China. And factory shutdowns or underutilization of production facilities could lead to order cuts and, in turn, fewer or delayed sales.

China consumes roughly 30% of global light-vehicle production, so the auto end market's vulnerability could affect parts of this market because of increasing semiconductor content in vehicles. According to S&P Global Ratings' auto team estimates, shutdowns in China are likely to knock 2%-4% off total annual production in the Wuhan region, which is home to about 9% of Chinese auto production. China may further extend shutdowns beyond Hubei to limit contagion risk, possibly affecting up to half of China's auto and auto-parts production (see "The Coronavirus Dashes Recovery Hopes For Global Autos," Feb. 5, 2020). Issuers with large auto exposures such as NXP Semiconductors N.V., Texas Instruments Inc., Analog Devices Inc., and Maxim Integrated Products Inc. could see orders pushed out if auto production slows.

Semiconductor firms with high revenue exposure to Apple, such as Qualcomm Inc. and Broadcom Inc., will likely be affected over the near term. Qualcomm commented that its modem shipment will be down 13% sequentially in the March 2020 quarter, about 14% lower than analysts' consensus expectation, incorporating the potential demand change due to the coronavirus. Its competitor, Taiwan-based MediaTek Inc., lowered its 2020 forecast for 5G smartphone sales by 15% to 170 million units, citing concerns over coronavirus and its impact on Chinese consumption. The impact on memory semiconductor vendors is less clear because output shortages from Samsung, SK Hynix, and Micron Technology Inc.'s manufacturing facilities in China could increase average selling prices, providing some offsets. Any production disruption will exacerbate the current trend of rising NAND average selling prices and help DRAM achieve demand supply equilibrium more quickly. This would also raise the input costs of products such as notebooks, servers, smartphones, etc., potentially hurting these OEMs' profitability.

While we haven't taken rating actions on any U.S. semiconductor firms as a result of the coronavirus outbreak, we are closely monitoring new developments that could impair II-VI Inc. and MACOM Technology Solutions Holdings Inc. They have less cushion within the ratings.

We also expect II-VI Inc.'s business to be significantly affected by the coronavirus. II-VI is an optical components and subsystems supplier. The company provided March 2020 quarter guidance that includes an estimated minimum $50 million (8%) reduction in revenue. It will try to shift some of its manufacturing to factories in Malaysia and Vietnam to reduce production losses. Leverage as of December 2019 is in the mid- to high-4x area versus our rating downside trigger for leverage sustained above 5x. Its ability to mitigate the outbreak and achieve targeted cost savings will be important to our near-term rating assessment.

MACOM's ongoing revenue declines from industry and macroeconomic issues will likely be extended in the first quarter if its Chinese customers' facilities remain closed for longer than expected. Our prior expectation for adjusted leverage to improve to 11x-12x and about $20 million free operating cash flow in fiscal 2020 will likely prove optimistic. MACOM is an analog semiconductor manufacturer.

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How Coronavirus Will Affect Europe, The Middle East, And Africa

In Europe, the heavy software and services mix of tech companies leaves the sector relatively less exposed. Semiconductor makers Infineon Technologies AG and STMicroelectronics N.V. are exceptions. Each generates about a third of its revenue from the China region, through sales of semiconductors to a variety of end markets in the automotive and industrial sectors, both directly to OEMs and through their channel partners. However, at this time we do not anticipate ratings impact for either.

Given their relative exposure, we estimate a 10% decline in China-based demand would reduce overall sales by 3%-4% for the two companies. This could be a short–term difficulty if a significant portion of their customers' factories in China reduce or suspend operations. However, our current base-case assumption of underperformance focuses on the January-March 2020 quarter, with recovery by September 2020 and above-trend growth in following quarters. This should narrow the negative impact by the end of 2020 and allow for a catch-up in 2021 as manufacturers address pent-up demand and replenish inventories. This assumption reduces the likelihood of negative rating actions based on January-June underperformance unless we decide to extend our timeframe for expected impact from the viral outbreak.

Several additional factors should also help to partly mitigate the short-term risks for Infineon and STMicro. In terms of production, both are relatively well positioned. They only rely on one or two main fabs in China, with most production insourced and in other countries, including a significant European presence. This may give Infineon and STMicro some production advantages relative to China-reliant peers if upstream interruptions are prolonged and shortages emerge. In addition, we expect lower sales into their downstream markets could be partly offset by reduced need for capital spending, helping to maintain cash flow measures despite lower revenue. We could also see reallocation by manufacturers to capacity outside of China, potentially making up for supply-chain issues in China.

Expect Rating Impact To Hardware OEMs And Semiconductor Firms If Supply Chain Disruption Persists

We should expect rating pressure on tech companies if the coronavirus takes longer to contain, which means the policy measures designed to limit the spread would remain in place for a sustained period. The negative effect would not be linear as the collapse of any part of the China manufacturing hub could have an outsize effect on the overall function of the global supply chain. Global tech spending could take a hit as a result.

Also, we expect more tech companies to diversify reliance on China as a manufacturing hub. As with the U.S.-China trade tensions over the past two years, the coronavirus outbreak will serve as a reminder that geographic concentration has its benefits, but also costs. While China continues to have an abundant and skilled labor force, it no longer has the comparative advantage of lowest labor costs, providing economic incentives for a pivot.

Although it might be costly to relocate manufacturing facilities, given startup costs and low productivity initially, the benefit of avoiding unexpected geopolitical events or health emergencies provides important reasons for tech companies to consider re-engineering their manufacturing processes and diversifying their production facilities.

Related Research

• Coronavirus Casts Shadow Over Credit Outlook, Feb. 11, 2020
• Coronavirus To Inflict A Large, Temporary Blow To China's Economy, Feb. 6, 2020
• The Coronavirus Dashes Recovery Hopes For Global Autos, Feb. 5, 2020