Rising stock, falling demand. This growing imbalance could create a cash flow and earnings headache for the Asia-Pacific tech hardware issuers we rate. For most, it's not so bad; for a select few, dips in cash flow could squeeze rating headroom and cloud outlooks. Makers of PCs and smartphones are likely to experience the weakness first, and it could spread to other technology hardware companies up the supply chain. We forecast global smartphone shipments to decline by 5% this year and PC shipments to fall by 10%.

For many manufacturers, inventory levels are at record highs, rising rapidly in the past few years. This stems from a combination of component shortages, global conflicts, and bottlenecks. During periods of strong demand, this shift has not materially affected manufacturers' operations or financials. But as demand turns, cash flow volatility could jump.

If this is managed well, manufacturers might be able to draw down on their inventory of raw materials and finished goods. This would provide working capital inflow even as operating cash flow declines. But consider what might happen if the inflection in demand is managed poorly. If inventory becomes obsolete, and channel inventory levels are high, manufacturers could face large losses amid falling profits and cash flows. Moreover, companies higher in the supply chain may struggle to forecast demand as downstream manufacturers rapidly cut orders to draw down on existing inventories.

Most of our Asia-Pacific technology hardware issuers have enough cash buffer to withstand a moderate shortfall in revenues. Some, however, such as Lenovo Group Ltd. and Xiaomi Corp., will have less rating headroom if cash flows are meaningfully lower than our base case. We base our positive outlooks on Lenovo and Xiaomi on the growing cash flow resiliency of their respective businesses. Lenovo is growing its service segment; and Xiaomi is monetizing its hardware users through internet services.

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Demand Slowdown Could Have Ripple Effect

Slowing PC and smartphone demand could affect demand for other components such as display panels, central processing units, graphics processing units, and peripherals. A plunge in demand could initially result in even higher days in inventory even as manufacturers draw down on existing stock. How quickly and how much of the inventory can be drawn down without steep discounting will determine the health of manufacturers' cash flows.

Since 2019, several factors have forced companies across the technology hardware supply chain to build inventory. These include component shortages, logistical bottlenecks, and the strong demand fueled by work-from-home measures and stimulus packages related to the pandemic. In addition, growing geopolitical tensions have pushed some manufacturers to hold more inventory in facilities across regions. As a result, days of inventory for many companies across the technology value chain are at their highest levels in more than a decade--from chip foundries and integrated circuit (IC) designers to PC and smartphone manufacturers.

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We expect global smartphone shipments to stabilize in the second half of 2022. This could result in some growth in the second half as the comparison is easier than that of last year. Smartphone shipments have declined for three consecutive quarters year on year since the third quarter of 2021. For now, the weakening demand appears to be somewhat isolated. For example, there is weaker consumer demand for PCs, particularly for low-end PCs, whereas demand for premium, gaming, and commercial PCs remains strong for now.

Moreover, the inventory buildup for most consumer electronics manufacturers remains largely contained to raw materials, where there is more flexibility in the event of a downturn. For example, some manufacturers could alternate the way they use some components to exploit stronger demand in certain regions or segments (for instance, corporate versus consumer or servers versus PCs).

Some Outlooks Face A Test

We see growing risks to companies across the technology value chain. The risks differ according to sub-markets. Chip foundries are a case in point. Foundries typically have low inventory risk given their sales are contractual; and they have a backlog of orders, which results in longer lead time for chip delivery. Some chip foundries, for example, could be more insulated from the strong demand for advanced node chip production, particularly from the adoption of electric vehicles (EVs), the cloud, or 5G networks. For example, Taiwan Semiconductor Manufacturing Co. Ltd. (TSMC) derives more than 50% of its revenues from the production of 7 nanometer (nm) and below. Foundries that gain a larger proportion of their end-demand from TVs, smartphones, and displays, could face greater uncertainty in chip demand (see "The Global Foundry Industry's Boom Is About To Deflate," Aug. 2, 2022).

In a demand downturn, on the other hand, PC and smartphone manufacturers would be most susceptible. For our rated PC and smartphone manufacturers, days of inventory have been rising despite a year-on-year decline in quarterly shipments. Quarterly smartphone shipments have fallen for several quarters since the third quarter of 2021. Fortunately for PC manufacturers, channel inventory remains relatively healthy, albeit rising back to pre-COVID levels during the latest June quarter, according to Lenovo. If PC distributors overestimate demand or if demand plunges, the situation could change rapidly.

The magnitude of the technology hardware downturn will govern whether shifting demand signals big losses and cash flow declines for technology hardware companies across the supply chain. One thing is for sure, uncertainty around EBITDA and cash flow is rising for many of our technology hardware issuers.

Tech Issuers' Exposure To Inventory Risks, Credit Rating Implications

Lenovo Group Ltd. (BBB-/Positive/--)  We have maintained our positive outlook on the 'BBB-' long-term issuer rating. This is despite our expectation of declining profitability and rising leverage ratios for fiscal 2023 (ending March 31, 2023) stemming from waning PC demand. Should hardware revenues start falling, we believe the company's Solutions and Services Group (SSG) can provide some cash flow resiliency and help maintain Lenovo's adjusted net debt-to-EBITDA ratio at below 1.0x over the next 24 months. However, this will still be higher than the 0.6x in fiscal 2022, given falling PC shipments in fiscal 2023 (the 2022 figures are adjusted pro-forma for the acquisition of PCCW's solutions business).

We forecast Lenovo's PC revenues and EBITDA will decline 6%-9% and 15%, respectively, in fiscal 2023. The company's elevated inventory level could lead to further losses beyond our base case if it cannot quickly work down its PC inventory amid weakening demand. Its days of inventory has increased from about 31 days in fiscal 2018 to about 51 days at the end of the first quarter of fiscal 2023, ending June 30, 2022.

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Raw materials have largely contributed to rising inventory days over the past few years, while the level of finished goods has remained relatively healthy. However, days of finished goods has been rising since fiscal 2020 and such increases could accelerate in future quarters should PC demand fall materially. Some of the rising inventory could also stem from a robust backlog of orders for servers.

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For now, we assume Lenovo can reduce PC inventories, and we forecast free operating cash flow of about US$1.5 billion in fiscal 2023, down from US$2.8 billion in fiscal 2022. This assumes that some of the PC inventory can be diverted to PC segments where demand remains strong, such as corporate and high-end consumer PCs. Additionally, Lenovo's server segment accounts for some of the inventory growth and server demand remains, for now, relatively robust.

Assuming a careful drawdown of inventories and no significant inventory losses, free operating cash flow could recover to over US$2 billion by fiscal 2024. Such cash flow should cover the company's dividends and potential share repurchases in the year.

Taiwan Semiconductor Manufacturing Co. Ltd. (TSMC; AA-/Stable/--)  We maintain our view that TSMC can maintain its strong profitability supported by high utilization, while the average selling price increases. This is despite a potential inventory correction leading to declining demand for certain products, which could last into 2023. Inventory levels are high across the value chain; and as end consumer demand weakens downstream semiconductor customers could slow procurement for respective semiconductor components.

TSMC's inventory turnover days increased to 81 days in the first quarter of 2022, up from 76 days and 49 days in the same quarter in 2021 and 2020, respectively. The increase largely reflects supply disruptions, which we believe will result in higher inventory for the next few quarters. However, TSMC has ample cash flow and net cash to maintain a higher inventory level, considering its net cash position of US$42 billion-US$45 billion over the next one to two years. This is despite minimum free cash inflow in the period due to the company's increasing capital expenditure (capex).

Moreover, unlike most foundry players, TSMC should continue to benefit from tight chip supply, particularly for high-performance computing applications such as cloud computing and artificial intelligence. We therefore see a relatively low risk to TSMC's high inventory levels and forecast its revenue to grow more than 30% in 2022.

Semiconductor Manufacturing International Corp. (SMIC; BBB-/Negative/--)  Our negative outlook on SMIC centers around the U.S. export restrictions on the firm. The company's operations could be heavily disrupted should such restrictions be extended to mature process nodes (28 nm or above), which comprise about 90% of its revenue.

We assess SMIC's inventory risk as relatively low. This is despite its inventory turnover days reaching a record high in 2021 and in the first quarter of 2022 (97 days and 104 days, respectively). The company's production and inventory planning are mainly based on orders contractually committed by customers. Moreover, committed orders are widely paired with prepayments, which helps mitigate the cash flow volatility from growing inventory. Prepayment received by SMIC in 2021 has more than offset its working capital uses on inventory in the year, resulting to a working capital inflow of US$114 million.

We maintain our forecast of SMIC's capacity utilization at above 95% over the next two years, with EBITDA margin around record levels of 54%-57%. Sales of smartphone and other consumer electronics are slowing (they together comprise more than 50% of SMIC's revenue). But we believe SMIC can capture demand from other end applications such as smart home and industrials. We base this on the foundry's technology leadership in domestic market and the Chinese government's push for semiconductor self-sufficiency.

To capitalize on such demand, SMIC will aggressively expand its capacity. We estimate capex of about US$5.0 billion-US$5.5 billion annually over the next two years, resulting in negative free operating cash flow of about US$1.4 billion-US$1.9 billion annually. However, the company is likely to maintain its net cash of US$5 billion over the next two years, compared with US$6 billion as of March 31, 2022. We estimate SMIC will benefit from about US$1.7 billion-US$1.8 billion of capital injections from local governments and state-owned entities each year.

Xiaomi Corp. (BBB-/Positive/--)  Softening end demand for consumer electronics could challenge Xiaomi's inventory management over the next several quarters. We expect the company's smartphone shipments will slide 5%-15% to 160 million-180 million units in 2022 from 190 million units in 2021. This could heighten the risk of impairments if the company is unable to draw down its large inventory. This is because existing smartphone inventory could face obsolescence given the rapid upgrade cycle of smartphone models.

At risk is Chinese renminbi (RMB) 25.3 billion of net inventory purchases over the past two years. Moreover, the inventory is becoming more complex, with a broader product offering. Xiaomi's internet-of-things (IoT) device revenues have grown significantly over the past few years at a 25% per compounded annual growth rate since 2018; but the segment is also seeing incremental weakness in 2022. If Xiaomi can draw down its inventory and limit inventory losses, we forecast a working capital inflow of about RMB2.8 billion for 2022, up from an outflow of about RMB15.8 billion in 2021.

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Over the next two years, we also expect Xiaomi's internet services segment to support more stable cash flows, only slightly offsetting increased investments for its new EV business. Internet services account for about 50% of Xiaomi's EBITDA, with relatively stable cash flows each year. Thus, we forecast positive free operating cash flows of about RMB8.1 billion-RMB8.6 billion in 2022, and RMB3.0 billion-RMB3.5 billion in 2023, versus RMB3.4 billion in 2021. This includes capex and R&D spending of about RMB4 billion-RMB5 billion per year to develop its EV business.

Dell Technologies Inc. (BBB/Stable/--)  We believe Dell is well positioned post its spin-off of VMware Inc. on Nov. 1, 2022 with adjusted leverage of about 1x and cash balances of US$12 billion, significantly above its minimal cash needs of roughly US$5 billion at the end of fiscal 2022 ending Jan. 28, 2022.

The sizable cushion should support the 'BBB' long-term issuer rating even if fiscal 2022 represents a peak in the PC cycle and if the profitability and cash flow of its Client Solutions Group (CSG) segment are under pressure should PC sales decline more than our forecast. This scenario holds even if the segment's operating margin falls below the recent 7% area.

We also note that while Dell's inventory days have been rising, the composition of its inventory remains relatively healthy with finished good and work-in-process inventory remaining relatively steady. The increase in raw material inventory days likely reflects the ongoing challenges with the supply chain for technology hardware.

Dell is also more diversified relative to peers such as Lenovo. Roughly 60% of its revenues are derived from CSG (PCs, tablets, peripherals, and software and services) and 40% of its revenues are from servers, storage, and networking. We also note that Dell has higher enterprise PC exposure relative to peers, which we believe should prove more resilient through a recession. Lenovo, on the other hand, derives roughly 70% of its revenues from PC and related hardware sales, not including related software and service revenues.

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HP Inc. (BBB/Stable/A-2)  PC unit growth should meaningfully reverse over the next year, driven by consumer weakness and increased risk of rising inventory levels. However, HP's favorable enterprise mix could provide some support. We still expect HP to generate free operating cash flow (FOCF) of about US$5 billion, given stronger corporate demand and a healthy backlog of orders. The healthy cash flow implies an adjusted debt-to-EBITDA ratio of about 1x in fiscal 2022 (ending Oct. 31, 2022), supporting our stable outlook on the 'BBB' issuer rating on HP. While leverage remains low, we anticipate that HP will operate in the 1.5x-2.0x range in fiscal 2023 when its completes a planned acquisition of Plantronics.

As for HP's rising inventory levels amid declining PC shipments, we note that its inventory days of finished goods have remained relatively stable at about 30 days. Moreover, HP noted some of the rise in inventory days derived from changes to supply chain logistics and related bottlenecks, rather than falling demand. Nevertheless, the company's supply-chain challenges and outsourced manufacturing strategies are company-specific risks worth monitoring, in our view.

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Related Research

• The Global Foundry Industry's Boom Is About To Deflate, Aug. 2, 2022
• TSMC Could Sustain Strong Profitability Amid Downstream Inventory Correction, July 22, 2022
• Industry Top Trends Update: Technology North America, July 14, 2022
• Lenovo's Cash-Flow Resiliency Could Be Put To The Test, May 31, 2022
• Xiaomi's Operating Strains Won't Ease Over The Next Few Quarters, May 23, 2022
• China Tech Braces For Short, Sharp Lockdown Effects From Shanghai, April 21, 2022

Editor: Lex Hall, design: Evy Cheung