Key Takeaways
- Lockdowns in Shanghai and surrounding areas will likely hit supply chains supporting our rated tech hardware firms in China.
- The entities have been steadily adding inventory to address expected COVID effects and geopolitical risks, and that excess supply is helping them manage the current lockdown.
- Entities' practice of isolating workers within facilities (closed-loop production) has also contributed to operational continuity.
- We believe the supply chain effects are short-term and manageable; longer term, entities focused on consumer electronics face greater risk from softening demand amid a decelerating global economy.
Mobility controls in Shanghai and surrounding regions will likely disrupt China's hardware companies. The affected areas comprise the country's technology heartland. Strict antivirus policies have already forced Pegatron Corp. and Quanta Computer Inc. to halt production in Shanghai. This is in addition to challenges of component shortfalls and logistics issues. S&P Global Ratings believes that inventory stockpiling and adaptive production measures among our rated firms will protect them from short-term supply disruptions.
This is a short-term risk, albeit with potentially acute effects for some, in our view. The government will likely protect some tech entities, such as semiconductor makers, from the most severe effects of its measures, on the view that the firms are important to the economy and the country's technological self-reliance.
Even as daily COVID cases in Shanghai stay around record highs, China's Ministry of Industry and Information Technology is planning to allow selected industries to resume operations. This demonstrates its desire to let strategic industries function as normal. As such, technology hardware supply outages should ease starting in late April to early May 2022, in our view.
This is a fast-moving situation with many unknown variables. If Shanghai's lockdown--China's most extensive in two years--expands to other regions of the country, the hit on supply chains, financial results, and consumer sentiment will amplify. In that case, we would need to reassess the supply chain effects of tech firms, and the degree of ratings buffer entities may need within existing levels.
To anticipate such effects, we look at supply chain exposure and possible disruptions for Xiaomi Corp., Lenovo Group Ltd., Hon Hai Precision Industry Co. Ltd., Taiwan Semiconductor Manufacturing Co. Ltd. (TSMC), and Semiconductor Manufacturing International Corp. (SMIC). Xiaomi has the most exposure of this group. The company is exposed to both supply-chain outages and softening demand for its smartphones. All five entities have sufficient headroom to maintain current ratings.
Table 1
| Key Ratings Risks Before China's Large Tech Hardware Firms | ||||
|---|---|---|---|---|
| Downside scenario | ||||
| Xiaomi Corp. (BBB-/Positive/--) | We could revise the outlook to stable if Xiaomi's internet services (excluding financial services) stop growing. Given how the segments are intertwined, this will likely indicate marked operating weakness. The latter could happen if Xiaomi is unable to increase its active user base, particularly in China, or effectively monetize users. Market-share losses or declining shipments of Xiaomi's smartphones would be likely reasons. Given the likely scale of investment, we will closely watch the company's development of EVs and its execution in this area. | |||
| Lenovo Group Ltd. (BBB-/Positive/--) | We could revise the outlook to stable if we believe Lenovo's debt-to-EBITDA ratio will not fall below 1.0x, or if the company's growth in software and service revenue decelerates materially. This could happen if Lenovo significantly increases debt-funded investments and acquisitions, or if its profitability declines, given falling PC sales and slower growth in service revenue. | |||
| Hon Hai Precision Industry Co. Ltd. (A-/Stable/--) | We could lower the rating on Hon Hai if: (1) The company adopts a more aggressive financial policy such that its ratio of total debt to EBITDA increases to more than 1.5x for an extended period. This could result from Hon Hai taking on more debt due to overly aggressive capital expenditure, overseas investment, or acquisitions. We may also lower the rating if its working capital management deteriorates, or its competitive advantages weaken such that Hon Hai's margins fall; or (2) Hon Hai's return on capital falls below 12%, due to deteriorating cost and technology advantages, loss of key customers, or aggressive expansion into competitive product segments. | |||
| Taiwan Semiconductor Manufacturing Co. Ltd. (AA-/Stable/--) | We could lower the rating on TSMC if: (1) The company fails to maintain its leading technology position and loses market share, resulting in significant deterioration in its profitability and cash flow, or (2) The company changes its prudent financial policy through more aggressive shareholder distributions or mergers and acquisitions and takes on high leverage. A ratio of debt to EBITDA exceeding 1.0x for an extended period, increased cash flow volatility due to mergers and acquisitions, or a weakening competitive position could indicate such a change. | |||
| Semiconductor Manufacturing International Corp. (BBB-/Negative/--) | We could lower the rating if we believe U.S. suppliers will not receive the necessary export licenses to provide SMIC with key equipment, components, and raw materials for the operation and expansion of its mature process nodes (28nm or above). The company's operations could face serious disruptions without such equipment or components. We could also downgrade SMIC if the company's debt-to-EBITDA ratio exceeds 2x. This could happen if its cash flow generation deteriorates materially because of: (1) heightened U.S. restrictions; or (2) aggressive investments in capacity or R&D. | |||
| EVs--Electric vehicles. nm--Nanometer. R&D--Research and development. Source: S&P Global Ratings. | ||||
Xiaomi
Xiaomi faces the possibility of component shortages and logistical disruptions. For instance, lockdown in Shanghai could delay the delivery of chipsets the company builds into its smartphones. The company has kept a good reserve of components, which could slightly offset the risk over the short term. Xiaomi's raw material inventory--largely key components--is up 23% year-over-year.
Chart 1
China's smartphone market is showing signs of weakness. Over the first two months of the year, smartphone shipments in the country dropped 23%, according to China Academy of Information and Communication Technology. If demand weakness continues, this may pose a greater risk to business performances than supply constraints.
Accordingly, some pressure on Xiaomi's hardware sales is likely. We revised down our forecast of Xiaomi's smartphone shipments in 2022 to 190 million units from 210 million-220 million units. This is based on our expectation that global smartphone shipment will drop 2% in 2022. China's mobility restriction will likely dampen near-term consumption in the Yangtze River Delta. This is on top of slowing domestic economic growth and ancillary effects from the Russia-Ukraine war.
The rating outlook for Xiaomi is still positive. Xiaomi can likely maintain its global market share at around 14% to 16%. This should support monetization of internet services. Compared with its domestic smartphone peers, Xiaomi could see less disruption from lockdowns due to its lower dependence on offline sales. The company's ample net cash of about Chinese renminbi (RMB) 50 billion in 2021 adds to the ratings buffer on the firm.
Chart 2
Lenovo
COVID lockdowns should have a somewhat limited effect on Lenovo's manufacturing operations. The company has a diversified manufacturing base and its largest manufacturing facility is based in Hefei--an area so far unaffected by lockdowns. The company may have experienced some near-term supply shortfalls in late March at its Shenzhen facility given lockdowns in that region. Even so, near-term supply shortfalls could be filled in later quarters given healthy PC demand. PC shipments during first quarter, though down, still exceeds pre-COVID levels despite COVID restrictions in certain parts of China. Lenovo also maintained its leading global market share.
There are still some risk points for Lenovo. It is not clear how severely the restrictions in Shanghai and other regions in China will affect Lenovo's supply chain. The company has steadily increased its inventory. However, its stockpiling is uneven, and it may yet run out of some key components.
While supply disruptions are the most visible and immediately critical risk in front of Lenovo. Global PC demand will likely be the biggest variable for Lenovo's future revenue and profits. Slowing economic growth in China--which accounts for about one-quarter of its sales--and globally has the potential to significantly reduce Lenovo's hardware sales. Such sales account for about 90% of Lenovo's revenues and 60% of its operating profits.
Our positive outlook on Lenovo hinges on the growth of the company's service revenues. This increases the contribution of recurring sales, moderating the potential for volatile cash flows from emanating from the group's always cyclical hardware sales. Lenovo's ability to keep its cash flow and sales stable through a downcycle, or significantly grow its service revenue contribution, will be key to any upward rating action on the firm.
Chart 3
Chart 4
Hon Hai
We don't expect the recent lockdowns in Shanghai and Kunshan to meaningfully affect Hon Hai's operations. They are not sites for Hon Hai's massive electronic manufacturing services (EMS). The company's operations in Shenzhen, which is one of its major production hubs for EMS, was not meaningfully affected by prior COVID restrictions.
However, if COVID restrictions expand to other regions and cities, it could have a more meaningful effect on the company. One of the company's most important EMS sites is in Zhengzhou. If a shutdown affected Zhengzhou--in particular during the peak season for iPhone assembly--this could inflict larger damage on Hon Hai. So far the firm's Zhengzhou operations have been resilient. The site was hit by heavy rainfall in July 2021, and has been through several COVID outbreaks over the past two years. The effect on Hon Hai's output was moderate.
Hon Hai's performance should stay steady, in our view. The company has maintained stable operations through sporadic component shortages. Hon Hai should maintain its share of Apple Inc.'s hardware outsourcing contracts over the next one to two years. Apple will likely account for 50%-55% of Hon Hai's revenue in the period. Moreover, we believe enterprise applications, especially servers, as well as other businesses such as electric vehicles (EVs) could support Hon Hai's growth, offsetting weaker sales for PCs and other consumer electronics stemming from a slowing global economy.
SMIC & TSMC
We see minimal impact on SMIC and TSMC. Both foundries have maintained normal production for their sites in mainland China, thanks to their ability to use automation and closed-loop production (isolating staff within sites, to minimize COVID infections). Separately, given the government's strategic emphasis on semiconductors and foundries, the industry will likely be the last to be affected by any COVID restrictions. Chipmakers are also experiencing very high demand right now. Order backlogs are long. This somewhat supports the pricing power of SMIC and TSMC amid increasing production costs.
SMIC and TSMC should be able to manage knock-on effects from the Russia-Ukraine conflict. Ukraine and Russia are key suppliers of certain semiconductor raw materials such as neon gas. Supply disruptions should be buffered by high inventory, efficiency, and technology improvements that lower material consumption, and better supply diversity after Russia's annexation of Crimea in 2014 (see "Impact On Tech From Russia-Ukraine Conflict Muted For Now, With Risk Of A Further Macroeconomic Slowdown," published March 18, 2022, on RatingsDirect). Separately, the two companies have minimal revenue exposure to both countries.
Editor: Jasper Moiseiwitsch
Related Research
- Impact On Tech From Russia-Ukraine Conflict Muted For Now, With Risk Of A Further Macroeconomic Slowdown," March 18, 2022
This report does not constitute a rating action.
| Primary Credit Analyst: | Hins Li, Hong Kong + 852 2533 3587; hins.li@spglobal.com |
| Secondary Contacts: | Clifford Kurz, Hong Kong + 852 2533 3534; Clifford.Kurz@spglobal.com |
| David L Hsu, Taipei +886-2-2175-6828; david.hsu@spglobal.com |
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