Global tech hardware firms have largely completed phase one of their shift out of China; phase two will be much more disruptive and costly. S&P Global Ratings believes this reordering of supply lines is happening in stages. The current focus on adding "midstream" tech production outside of China presents more credit risks than the prior stage, the expansion of downstream output outside the country.

The reallocation of midstream capacity from China will involve even more spending, higher ongoing operational costs, and the possibility of botched executions. More significantly, we assume this phase will be hard to reverse as it involves heavy investment in plants and equipment that will be difficult to move.

Moreover, as the rebalancing of midstream capacity has only occurred over the past one or two years for many firms, we are only getting an early glimpse of the effects. We believe the costs and the drag on operations over the next decade will accelerate, and will be substantial.

The first wave of tech hardware firms expanding capacity outside of China largely involved downstream electronic manufacturing services (EMS) firms building in countries such as Vietnam and India. This was less risky and less costly to execute. The production facilities are not too capital intensive; they can be rebuilt in a new country for moderate cost. Entities have easily found low-cost labor in the new markets.

Chart 1

The next phase will involve midstream tech hardware firms adding capacity outside of China. We assume this transition will be meaningful partly because the rebalancing of downstream capacity outside of China happened so quickly. The biggest EMS entities have been allocating most of their new investment outside of China since 2018 (see chart 2), which is well captured in data showing swelling smartphone exports coming out of India (see chart 3).

However, midstream tech firms will find it harder to reduce reliance on China. Midstream entities need to achieve high volumes that justify their steep fixed costs. For this reason, they want centralized production with suppliers and customers close at hand, in addition to a specialized work force.

Chart 2

Chart 3

Few, if any, geographies match China for these features. Producers know they can come to the country and plug into a thriving ecosystem of suppliers, infrastructure, and laborers. Trying to replicate all of this in a new market will invariably involve greater cost and lower efficiency.

Midstream suppliers are likely only shifting midstream production from China because their customers are requesting it. For example, we forecast Foxconn Industrial Internet Co. Ltd., China's largest manufacturer of high-precision components, will significantly increase capital expenditure (capex), most of which is likely to be outside of China. Such investments are likely at the request of its largest customers.

The pandemic also taught customers a painful lesson about the risks associated with overly concentrated supply chains. During a pandemic-connected lockdown of Shanghai, which began in February 2022, Apple Inc. faced significant supply constraints during the fiscal quarters ending March 31, 2022, and June 30, 2022. This was due to the loss of some final assembly production in Shanghai.

While Apple's financial performance was better than feared, the lockdown emphasized to its management the importance of diversifying the supply-chain network.

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The Push For 'China +1' Is Accelerating

Tech hardware producers will likely speed up investment into new midstream capacity outside of China between 2024 and 2026. This capex trend has been apparent for a while among contract manufacturers. It is also well reflected in China's declining share of tech hardware exports--downstream and midstream--to the U.S. (see chart 5).

Chart 5

The geographic exposure of large producers in several tech subsectors has shifted notably in recent years, in terms of the placement of entities' long-term assets by geography. We view asset investment as a leading indicator for shifts to the geographic mix of producers' capacity and revenue.

Of the 14 midstream tech hardware firms we track, exposure to China by fixed assets or noncurrent assets dropped to 26% in 2023 from a peak of 30% in 2021. More importantly we believe some of these companies have only just started adjusting their exposure to China, with the process starting for many at the end of fiscal 2022 (ending March 31, 2022).

Over half of new investment by such entities in the past two years was spread across the Americas, the EU, or Asian geographies such as Taiwan, Thailand, Malaysia and India. Based on the capex plans disclosed in 2024 by some key tech hardware firms, the diversification trend will likely continue.

Push and pull factors at play

Global tech hardware firms will incur steep costs, disruptions and lost efficiency in moving out of China. An important reason why they are taking this on lies in the incentives and penalties applied by Western governments, to lessen their dependence on China.

For example, the U.S. export controls on leading-edge semiconductors and AI technologies have hit AI server output in China. Producers are relocating key sections of AI server production, such as graphics processing unit modules, motherboard and server assembly, away from the country. This relocation of production secures entities' access to advanced AI chips that the U.S. prohibits for export to China.

Likewise, the U.S. is increasingly applying restrictions on tech items imported from China. For example, Washington may be about to issue rules restricting the import of Chinese connected vehicles, according to media reports, on the view that the onboard integrated network hardware could threaten data security.

Governments are also using cash to lure firms to base operations in their country. Incentives include US$52.7 billion for research and manufacturing under the CHIPS and Science Act by the U.S., and India's production link incentive scheme. Meanwhile, firms are becoming more wary of the possibility of punitive tariffs when exporting from China, and of rising production costs and stiffer competition in the country.

Midstream Players' Ex-China Moves: The Credit Effects

We rate--and therefore have direct visibility on--a batch of midstream tech firms that are highly present in China. We review these firms and their intentions in terms of building capacity outside of the country. While the credit implications are low to moderate, the capex involved typically is not. This is also a fast-moving trend, and the credit effects may escalate.

Foxconn Industrial Internet Co. Ltd. (A-/Stable/--)

Does what:  Foxconn is a contract manufacturer in mainland China that makes several of the key components used in smartphones and other devices. Foxconn and its parent, Taiwan-based Hon Hai Precision Industry Co. Ltd., are responsible for assembling most of Apple's key products. The firm is a bellwether for the midstream sector.

Mainland China exposure:  Most of Foxconn's production remains in China; however, the company is accelerating its capacity footprint across India, Mexico, and Vietnam.

Capital expenditure:  We forecast its annual capex to top Chinese renminbi (RMB) 13 billion over the next two years, versus just RMB6 billion-RMB9 billion in the past three years. Much of this spending will be used to build production capacity outside of China.

Rating implications:  Foxconn has substantial financial resources to cover its heavy global investment, with few credit implications. The firm had a net cash balance of RMB29 billion as of Dec. 31, 2023. We project the firm will have operating cash flow of RMB27 billion in 2025.

Moreover, Foxconn's EBITDA margin should remain steady at about 6%. The higher costs related to its overseas expansion will likely be offset by improving margins related to its fast-growing cloud segment, bolstered by rising sales of AI servers.

Chart 6

TDK Corp. (A-/Stable/A-2)

Does what:  TDK is a Japan-based general electronic component maker with strength in magnetic technology. The company has a broadly diversified product portfolio, consisting of passive components, sensors, magnetic application goods, and energy application products.

Mainland China exposure:  TDK's China assets decreased to about 30% of the total in fiscal 2024, ending March 31, 2024, from 45% two years earlier. The decrease was mainly due to the sale of its midsize battery business to a joint venture with China-based Contemporary Amperex Technology Co. Ltd. Meanwhile, TDK continues to invest outside of China, particularly in India, in line with its local production strategy.

Capital expenditure:  TDK will remain free cash flow positive over the next one to two years despite higher investment in passive components and sensor segments. The elimination of capex needed for the battery business that it sold offsets some of this increased investment need.

Rating implications:  We don't expect the company's overseas expansion will significantly affect its profitability and leverage, thanks to its diversified business portfolio and operating efficiency. EBITDA margins will remain high at 17% or above. We expect the ratio of debt to EBITDA to remain less than 1.0x over the next one to two years.

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Vishay Intertechnology Inc. (BB+/Stable/--)

Does what:  U.S.-based Vishay is a broadly diversified supplier of discrete semiconductors (including diodes and optoelectronics) and passive components (including resistors, inductors, and capacitors).

Mainland China exposure:  Vishay has a meaningful exposure to China with more than 30% of its full-time equivalent employees (R&D and manufacturing) in China, and more than one-third of revenues from Asia (primarily China).

Capital expenditure:  Vishay has increased its capex to well above US$300 million per annum in the past two years, up from US$218 million in 2021. The company is undergoing capacity expansion outside of China and is likely to spend more than US$1 billion in total over the next two years. Such expenditure will occur primarily in Mexico, Taiwan and Europe.

Rating implications:  Vishay has a sufficiently strong balance sheet to undertake its planned product development and capacity expansion without significantly affecting its credit metrics. Moreover, Vishay has a diversified end-market exposure.

Chart 8

Delta Electronics Inc. (BBB+/Stable/--)

Does what:  Taiwan-based Delta is a global provider of power electronics, industrial and building automation, and infrastructure power systems. The company's power electronics business, including electric vehicle (EV) parts, contributed 62% of its revenue and roughly 88% of its operating profits in the first nine months of 2023.

Mainland China exposure:  Delta has about 17% of its noncurrent assets in mainland China. The company will continue to diversify its production away from mainland China and Taiwan, into India, Thailand, Eastern Europe, and the U.S.

Capital expenditure:  We estimate capex will reach new Taiwan dollar (NT$) 30 billion in 2024 and remain at about NT$25 billion for both 2025 and 2026. Such expenditure will focus on product segments such as AI servers, EVs, EV charging stations, and micro grids (smaller electrical grids that can be controlled as a single grid).

Rating implications:  Delta can maintain net cash despite elevated capex. This is supported by the company's high cash on hand of around NT$92 billion as in 2023, and strong annual operating cash flow of NT$50 billion-NT$65 billion in 2024-2026.

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TE Connectivity Ltd. (A-/Stable/A-2)

Does what:  Switzerland-based TE Connectivity designs and makes products that connect and protect the flow of power and data (including connectors, sensors, and antennas) inside consumer and industrial products. It has customers in the automotive, data and devices, medical, energy, appliances, commercial transportation, aerospace and defense, oil and gas, and industrial equipment industries.

Mainland China exposure:  TE Connectivity's China assets account for about one-fifth of all assets. Likewise, its China revenue is about one-fifth of the total. To the extent that the company generates a rising share of orders from China, we do not believe its China manufacturing will decrease meaningfully over the next two years.

Capital expenditure:  TE Connectivity will likely continue to spend about 5% of its revenue on capex. The company will raise its investment into AI-related data center applications and vehicle electrification.

Rating implications:  TE Connectivity will remain cash flow generative with free cash flow totaling about US$2.5 billion per annum in 2024 and 2025. We do not expect a material change in its credit metrics or operations.

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Amkor Technology Inc. (BB/Stable/--)

Does what:  U.S.-based Amkor is an outsourced semiconductor assembly and test (OSAT) services provider to semiconductor and device makers. Amkor offers packaging technologies, including advanced (used in thinner packages, such as mobile handsets) and legacy (used in larger packaging applications, such as autos).

Mainland China exposure:  Amkor has moderate exposure to mainland China, as more than half of its property, plant and equipment (PPE) spend is in Korea. It has been slowly diversifying away from China as it allocated roughly 12% of PPE spend in China as of 2023, down from 15% in 2021. Its Asia-Pacific (excluding Japan) revenue also dropped to around 11% in 2023, from 16% in 2021.

Capital expenditure:  We project Amkor to spend around US$750 million in capex in 2024, similar to what it has spent in the past, as it invests in advanced technology services. This will mainly be for expansion into Vietnam, Portugal, and Taiwan.

Rating implications:  While capital intensity will continue to be over 10%, we expect Amkor to keep leverage below 0.5x, due to improved balance sheet cash, stable EBITDA margins, and moderate financial policies. That will give Amkor sufficient cushion to our rating on the firm, even as it spends to diversify its global footprint.

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Amphenol Corp. (BBB+/Stable/A-2)

Does what:  U.S.-based Amphenol designs and manufactures electronic connectors, sensors, and cabling products used in cars, industry and communications.

Mainland China exposure:  Amphenol's China revenue and asset exposure has remained above 20% over the past years. Though we expect this to remain steady, this share may change rapidly due to its acquisitive growth strategy.

Capital expenditure:  The firm's capex will likely increase slightly to 3.0%-3.5% of revenues in 2024, from about 3% in 2023, as it invests to support growth from AI data centers.

Rating implications:  We forecast free cash flow to increase to at least US$2 billion helped by EBITDA growth from this AI boost. This is offset by large shareholder distributions and acquisitions, such that its ratio of net debt to EBITDA will remain well above 1x.

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TTM Technologies Inc. (BB/Stable/--)

Does what:  U.S.-based TTM primarily makes printed circuit boards serving diverse end markets such as networking, computing, aerospace and defense (A&D), automobile, medical, and industry, with a focus on products with high manufacturing complexity.

Mainland China exposure:  The share of TTM's assets in mainland China fell to about 20% in 2023, from about 25% in 2021. The decline was partly driven by its acquisition of Telephonics in 2022, and an increase in U.S. manufacturing to serve its mostly U.S.-based A&D customers. The company also opened its first factory in Malaysia in response to customer concerns about supply-chain resiliency.

Capital expenditure:  We expect the firm's capex to grow to about US$190 million per annum over the next two years, from US$160 million in 2023.

Rating implications:  TTM's increased capex has no immediate ratings impact. We view as positive for its profitability the firm's manufacturing diversification, its focus on moving up the value chain, and its push to provide more engineered products.

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March Of The Midstream

China's place in global tech supply chains is both deeply entrenched and highly politicized. Most tech hardware firms would be happy to remain ensconced in the efficient, low-cost Chinese ecosystem, in our view.

The question through this process has always been, is a tech supply chain outside of China even viable? We were skeptical about this when we looked at the question before, believing that China's large domestic market and industrial expertise would keep producers largely tied to the country for a long time (see "Cutting China From Supply Chains--Easy To Say, Hard To Do," June 1, 2022).

Our views are shifting. A diversification from China is underway, mostly because global customers are asking for it. We have seen a very clear reallocation of investment by EMS firms of downstream assembly. The majority of smartphones sold outside of China, for example, could soon be made outside of China.

Chart 14

Midstream tech hardware firms are also now building capacity outside of China. This is a more ambitious, and riskier, project for firms. The reallocation of some of this midstream tech production out of China will be an important proof of concept. If successful, global tech firms may someday be able to produce tech goods using a supply chain that largely sits outside of China.

This event is also an outcome of the trade tensions between the U.S. and China. Once perceived as unlikely, the splitting (China/non-China) of the technology supply chain is accelerating. The cost of this transition will climb as firms add geopolitics to their set of credit risks.

Writer: Jasper Moiseiwitsch

Digital Designer: Evy Cheung

Related Research

• Slow-Motion Shakeup? Asia's Role In Global Supply Chains Is Slow To Change, Aug. 27, 2024
• China's Chip 'Moon Shot'--The Response To Restrictions, Nov. 2, 2023
• China's global reach grows behind critical minerals, Aug. 24, 2023
• Cutting China From Supply Chains--Easy To Say, Hard To Do, June 1, 2022
• Rest Of Asia To Delink From China In 2022, March 8, 2022