What the Sharp-Foxconn Tie-up Suggests

Toward the end of March 2012 news came in of a business and capital tie-up between Sharp Corp. and Taiwan’s Foxconn Group, the core company of which is Hon Hai Precision Industry Co. The announcement caused quite a stir, since the partnership would essentially be a rescue of Sharp by Foxconn. And it brought into focus the cul-de-sac the Japanese electronics industry is in, the rise of the companies of Taiwan and other emerging economies, and the search for new value chains.

Foxconn Chairman Terry Gou has already paid ¥66 billion personally for a stake of some 40% in a Sharp plant in Sakai, Osaka, producing large liquid crystal display panels for television sets. This plant is the primary culprit behind Sharp’s red ink, and Sharp and Foxconn are now jointly operating it. A proposed tie-up now on the table is to go beyond that, giving the Foxconn Group close to 10% of the stock of Sharp itself for about ¥67 billion and making it the corporation’s largest shareholder. The negotiations have stalled, though, due to a steep fall in Sharp’s share price. Although Gou came to Japan in late August in the hope of promoting the deal, he soon returned home without even holding a planned press conference. There have been few further reports on the negotiations, and at this point in November, the deal is still up in the air.

Behind Sharp’s Fall from Grace

Not long ago Sharp had a sterling reputation, but now it is struggling just to stay afloat. Evidently the business model employed by Japanese electronics manufacturers has become outdated. These corporations used to be able to sustain solid growth by releasing products nobody else was supplying, incorporating their own top-flight components in the product lines. Sharp TVs with LCD screens are a case in point. Over time, however, many consumers ceased to see sufficient value in Sharp’s differentiation strategy to justify the high prices it asked them to pay.

The goods and services for which people are willing to pay high prices these days have changed. In the electronics field, interest has turned to devices that deliver greater pleasure from using the Internet. Consumers are snapping up such products as the iPhones and iPads produced by Apple Inc. of the United States, and they are also spending heavily on content, including the applications that go along with these products. In the meantime, as a result of the rapid advance of electronics makers in South Korea, Taiwan, and other economies, LCD panels and TVs have become just another commonplace commodity. This means that Sharp’s business model—which is based on producing LCD TVs with enhanced picture quality, incorporating panels it manufactures in-house and selling them at premium prices—has ceased to be effective.

In response to this trend, Sharp had taken action to head it off. Deciding to lean more heavily on sales to other TV makers, it constructed a “tenth generation” plant in Sakai for making LCD panels more efficiently than any other plant in the world. This plant, it thought, would keep it a step ahead of its rivals. This decision also meant relegating its own flat-screen TVs to a secondary position in its strategy. But as soon as business began turning up, we are told, it gave priority to supplying panels to meet in-house needs. Because it was not wooing business clients aggressively, the buyers of its panels soon began to desert it. When the world economic slump grew more critical and the yen rose higher in 2011, accordingly, the market for the Sakai plant’s output dried up. With this plant incurring huge losses, separating it from Sharp’s operations suddenly became an urgent need.

The crisis at Sharp goes beyond that. Currently its managers are trying to revive the business by making small and medium-size panels, demand for which is strong as a result of the brisk sales of smartphones and tablet computers. In this area Sharp can take advantage of its outstanding IGZO technology, which uses indium gallium zinc oxide as the semiconducting material in LCD screens. At present, however, mass production using IGZO technology is hobbled by a low yield rate, and it does not look likely to contribute to the company’s profitability. Under the circumstances, Sharp’s ability to turn itself around remains in doubt.

Foxconn’s EMS Business Could Also Falter

From Foxconn’s perspective as well, the proposed tie-up cannot be easily abandoned. This is because the Taiwanese company may be unable to maintain its momentum into the future without the alliance. Foxconn is a parts maker founded by Chairman Gou in the 1970s. Its dramatic growth got underway in the 1990s when it set itself up as an OEM, or original equipment manufacturer, of personal computers at plants in China. Over the next decade or so it expanded its operations over all fields of electronic products, and today it is said to be the world’s largest EMS, or electronic manufacturing services, firm—one that designs, tests, manufactures, assembles, and repairs components and finished products for the brand companies. Because Foxconn works in the background without selling to consumers under its own brand name, probably many Japanese had never heard of it until the announcement last March that it had entered tie-up talks with Sharp.

The Foxconn business model rests on two foundations: the huge size of its operations and the ability to utilize low-cost production based in China. Today, however, the company has gone almost as far as this model can take it. Since it already contracts to make products across a broad range of electronics manufacturing, it has little free room for horizontal expansion into new business fields. Even more damaging, wages in China are on the rise, sapping Foxconn’s ability to engage in low-cost production. Under the circumstances, its profit rate has gradually declined over recent years. While temporary or cyclic factors may be among the reasons for this profitability downturn, the two factors I have just cited are thought to be involved.

Clearly Foxconn is not passively watching this take place. As an EMS firm that needs to avoid conflicts with its clients, it is holding back from developing and selling electronic products under the Foxconn brand. But it has taken steps to expand in other directions, such as by advancing into the distribution and retail businesses, and it is also shifting production from the Chinese coastal region into interior areas where wage levels continue to be low. Still, such strategies have limits. Nobody can say whether its strengths will give it an advantage in the distribution sector, and the relocation of plants deeper into China cannot generate sustainable profits due to the eventual rise of wages there.

The Option of Vertical Integration

There is still one more road Foxconn can take to further refine its business model: vertical integration within the sphere of contract manufacturing. In other words, it can seek to realize additional added value from production of parts and components. Having come into being as a parts maker, Foxconn even today is reported to be dependent on supplies of parts and components for a sizable share of its total profits. But it still has leeway for strengthening this business through a vertical advance into manufacturing of LCD panels, one of the most costly components of finished electronic products.(*1) Even before it began exploring a partnership with Sharp, in fact, it approached Hitachi to inquire about cooperation in flat-screen displays.

Foxconn’s primary target is Apple, its largest customer. It already has a prominent subsidiary involved in the production of LCD panels, but it lacks the ability to satisfy Apple’s needs. If it could supply components incorporating small screens made by Sharp, which is better positioned to meet Apple’s demands, it would be able to strengthen its collaboration with the American giant, using that as a springboard for a new phase of growth. This is also an attractive option from the perspective of Apple, which is engaged in a battle with Samsung Electronics of South Korea over smartphones and tablets and would like to cut down on its procurement of parts from Samsung. In fact, rumor has it that the talks between Sharp and Foxconn began at Apple’s suggestion. Be this as it may, there can be no doubt that Gou, who regards Samsung as a rival, needs to have Sharp on his side.

Foxconn’s Follow-up Moves

Foxconn is already at work reinvigorating the Sakai plant it is jointly running with Sharp. What the plant needs is a larger outlet for its production so that capacity utilization can be lifted to a higher level. While the placement of the plant under the Foxconn umbrella is reported to have given the operating rate a boost, Gou has taken a further step. Using LCD panels procured from Sakai, he has launched sales of 60-inch TVs at less than half the conventional price. (In the United States these are being sold under the Vizio brand.) This is not a set that Foxconn is making under contract but one that it has developed on its own.

Looking behind this strategic move, we can discern the possibilities and tasks of the new Foxconn business model. The model is pinned on a plant turning out LCD panels, and it requires Foxconn to drum up demand by itself since the volume of contracted orders alone is insufficient to fully absorb the plant’s enormous capacity.

This new business model faces two potential pitfalls. First, Foxconn may come into collision with manufacturers it is supplying. In Taiwan the firm is hoping to avert this by presenting the TV with no brand name. Second, Foxconn will have to deal directly with ordinary consumers, an area in which it has little marketing experience. How well Foxconn performs in both these respects is bound to have an impact on its stalled negotiations with Sharp over a business and capital tie-up.

(Originally written in Japanese on November 13, 2012.)